THE RELATIONSHIP BETWEEN PROFITS, CASH FLOW TO EQUITY AND FIRM VALUE

Beginning with the cash budget identity, we show that the appropriately defined cash flows under the free-cash-flow valuation approach (FCF) are mathematically equivalent to the appropriately defined economic profits tinder the EVA (economic value added) approach. The concept of net operating profit after-tax (NOPAT), found by adding after-tax interest payments to net profit after taxes, is central to both approaches, but there the computational similarities end. The FCF approach focuses on the periodic total cash flows obtained by deducting total net investment and adding net debt issuance to net operating cash flow, whereas the EVA approach requires defining the periodic total investment in the firm. In a project valuation context, both FCF and EVA are conceptually equivalent to NPV. Each approach necessitates a multitude of adjustments to the accounting information available for most companies.