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LOS m: Discuss alternative definitions of cash flow used in price multiples, and explain the limitations of each definition. fficeffice" />

Q1. Which of the following measures of cash flow is most closely linked with valuation theory?

A)   Cash flow from operations (CFO).

B)   Earnings before interest, taxes, depreciation, and amortization (EBITDA).

C)   Free cash flow to equity (FCFE).

Correct answer is C)

FCFE is most strongly linked to valuation theory. Both remaining proxies are in need of significant adjustment to accurately measure cash flow in valuation.

 

Q2. If cash flow from operations (CFO) embeds financing-related flows, it should be adjusted by:

A)   subtracting (net interest outflow) × (1 - tax rate).

B)   adding (net interest outflow) × (1 - tax rate).

C)   subtracting capital expenditures.

Correct answer is B)

Cash flow from operations CFO should be adjusted to CFO + (net cash interest outflow) × (1 – tax rate), if CFO embeds financing-related flows.

 

Q3. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is best suited as a measure of:

A)   equity value.

B)   total company value.

C)   debt capacity.

Correct answer is B)

EBITDA is a pre-tax, pre-interest measure, which represents a flow to both equity and debt. Thus, it is better suited as an indicator of total company value than just equity value.