flows could have been defined before corporate taxes, in
which case the discount rate used should have been a
precorporate tax discount rate as well.
Allmeasuresofcashflowsstartwithaccountingearnings.In
thischapter,webeginwithadiscussionofthelimitationsof
accountingincomeandsomeadjustmentsthatareneededto
make accounting earnings usable. We follow up with a
discussionofthetaxeffect,focusingonthetaxratesthatwe
should be using to come up with after-tax income. The
reinvestment needs of the firmare thenexamined, with a
breakdown of what should be considered in capital
expenditures and working capital. We close with an
evaluation of different measures of cash flows to equity.
EARNINGS
Theincomestatementforafirmprovidesmeasuresofboth
theoperatingandequityincomeofthefirmintheformofthe
earningsbefore interest and taxes(EBIT) and netincome.
Whenvaluingfirms,therearethreeimportantconsiderations
in using these earnings. One is to obtain as updated an
estimateaspossible,givenhowmuchfirmschangeovershort
periods. The second is to correct earnings for accounting
misclassification.Thethirdisthatreportedearningsatthese
firmsmaybearlittleresemblancetotrueearningsbecauseof
limitations in accounting rules and the firms’ own actions.
Importance of Updating Earnings
Firmsrevealtheirearningsintheirfinancialstatementsand
annual reportsto stockholders.Annual reports arereleased
onlyattheend ofa firm’sfinancialyear,butweareoften