Under the cash-flow-based valuation approach,free cash flows can be used instead of dividends as the expected future payoffs to the investor in the numerator of the general valuation model because:
A) this approach focuses on earnings as a measure of the capital that a firm creates.
B) over the life of the firm, the free cash flows into the firm and cash flows paid out of the firm in dividends to shareholders will be equivalent.
C) over the life of the firm, the free cash flows out of the firm for investments and cash flows paid into the firm in dividends from these investments will be equivalent.
D) this approach focuses on wealth distribution to shareholders.

Question

Quizplus · Accepted Answer

The cash-flow-based valuation approach focuses on the cash flows that the firm generates and that are available to shareholders over the life of the firm. Free cash flows represent the amount of cash generated by the firm that is available to both debt and equity holders. While dividends are a distribution of earnings to shareholders, free cash flows represent the cash that is available to the firm's investors. Since free cash flows take into account capital expenditures and other investments that the firm makes, they provide a more comprehensive picture of the cash flows available to investors over the life of the firm. Over the long term, the total amount of free cash flows that are generated by the firm will equal the amount of cash that is paid out in dividends to shareholders. Therefore, free cash flows can be used instead of dividends in the valuation model.

Under the Cash-Flow-Based Valuation Approach,free Cash Flows Can Be Used