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The decision by Ford (NYSE:F) to eliminate its tax liability valuation reserve represents financial engineering in its truest sense. While, according to Bloomberg, the act will add $10-13 billion in net income this year, it has no impact on free cash flows.

Given the volatility in the automotive sector, there is little assurance that Ford will remain a tax-paying entity, given it has received refunds (a negative tax rate) in four of the past 10 years.

Consistent tax rate companies at any level normally also have cash flows that are more predictable; Ford, it cannot be argued, has been a historically consistent generator of free cash flows.

Owing to losses occurring during 2008, many entities were forced to establish or increase their valuation reserves based on their historical taxable income and projected future taxable income, including the expected timing of the reversals of existing temporary differences. If the entities operated at a loss for an extended period of time, were unable to generate sufficient future taxable income, or if there was a material change in the effective tax rates or time period within which the underlying temporary differences become taxable or deductible, these entities could be required to record a valuation allowance against all or a significant portion of their deferred tax assets, which could increase their effective tax rate for such a period substantially. This could affect cash flows for those firms that used a simple definition of cash flow as net profit plus depreciation.

Obviously, Ford management wished to avoid a continuation of this scenario.

Source: Ford: Engineering of the Financial Kind