{"id":18363,"date":"2021-07-22T13:31:32","date_gmt":"2021-07-22T13:31:32","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=18363"},"modified":"2025-11-27T19:59:50","modified_gmt":"2025-11-27T19:59:50","slug":"net-income-and-ebitda-as-proxies-for-cash-flow-in-valuation","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/net-income-and-ebitda-as-proxies-for-cash-flow-in-valuation\/","title":{"rendered":"Net Income and EBITDA as Proxies for Cash Flow in Valuation"},"content":{"rendered":"<p><script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Which reason most likely makes net income a poor measure of earnings in the discounted cash flow model?\",\n    \"text\": \"Which of the following reasons most likely makes net income a poor measure of earnings in the discounted cash flow model?\\n\\n1. It does not reflect the cash taxes paid by the firm.\\n2. It does not account for the depreciation tax shield.\\n3. It includes the effects of non-cash charges like depreciation.\",\n    \"answerCount\": 1,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is 3. Net income is a poor measure of earnings in the discounted cash flow model because it includes the effects of non-cash charges like depreciation. Since depreciation is a non-cash expense, it should be added back when computing cash flow available to equity holders.\"\n    }\n  }\n}\n<\/script><\/p>\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/A10ZXpSEZaM\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><\/iframe><\/p>\n<p>Using other measures of earnings like net income, EBIT, EBITDA, or CFO in the discounted cash flow model would give a wrong estimate of a company\u2019s value.<\/p>\n<p>Net income inappropriately:<\/p>\n<ul>\n<li>Includes the effects of <em><strong>non-cash charges<\/strong><\/em> like depreciation that should be added back to compute cash flow available to equity holders.<\/li>\n<li>Ignores cash inflow from <em><strong>net borrowings<\/strong><\/em>.<\/li>\n<li>Ignores cash outflow from <em><strong>FCInv<\/strong><\/em> and <em><strong>WCInv<\/strong><\/em>.<\/li>\n<\/ul>\n<p>EBIT inappropriately:<\/p>\n<ul>\n<li>Does not reflect the <em><strong>cash taxes<\/strong><\/em> paid by the firm.<\/li>\n<li>Ignores the effects of <em><strong>FCInv<\/strong><\/em> and <em><strong>WCInv<\/strong><\/em>.<\/li>\n<li>Does not account for the contribution of the <em><strong>depreciation tax shield<\/strong><\/em>.<\/li>\n<\/ul>\n<blockquote>\n<h2>Question<\/h2>\n<p>Which of the following reasons <em>most likely <\/em>makes net income a poor measure of earnings in the discounted cash flow model?<\/p>\n<ol style=\"list-style-type: upper-alpha;\">\n<li>It does not reflect the cash taxes paid by the firm.\u00a0<\/li>\n<li>It does not account for the depreciation tax shield.<\/li>\n<li>It includes the effects of non-cash charges like depreciation.<\/li>\n<\/ol>\n<h4>Solution<\/h4>\n<p><strong>The correct answer is C.<\/strong>\u00a0<\/p>\n<p>Net income is a poor measure of earnings in the discounted cash flow model because it includes the effects of non-cash charges like deprecation. Depreciation should be added back as it is a non-cash expense.<\/p>\n<p><strong>A is incorrect. <\/strong>Net income reflects the cash taxes paid by the firm. This is a reason why EBIT is a poor measure of earnings in the discounted cash flow model.<\/p>\n<p><strong>B is incorrect. <\/strong>Net income reflects the depreciation tax shield as depreciation is deducted when computing net income. <a href=\"https:\/\/mommabe.com\/modafinil-online\/\">https:\/\/mommabe.com\/<\/a>  This is a reason why EBIT is a poor measure of earnings in the discounted cash flow model.<\/p>\n<\/blockquote>\n<p>Reading 24: Free Cash Flow Valuation<\/p>\n<p><em>LOS 24 (h) Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"<p>\ufeff Using other measures of earnings like net income, EBIT, EBITDA, or CFO in the discounted cash flow model would give a wrong estimate of a company\u2019s value. Net income inappropriately: Includes the effects of non-cash charges like depreciation that&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,401],"tags":[216,402,466,459],"class_list":["post-18363","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-equity-valuation","tag-cfa-level-2","tag-equity-valuation","tag-net-income-and-ebitda-as-proxies-for-cash-flow-in-valuation","tag-reading-28-free-cash-flow-valuation","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Net Income and EBITDA as Proxies for Cash Flow in Valuation - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Understand why net income is a poor measure of earnings in the discounted cash flow model due to its inclusion of non-cash charges.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/net-income-and-ebitda-as-proxies-for-cash-flow-in-valuation\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Net Income and EBITDA as Proxies for Cash Flow in Valuation - 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