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Define cash flows from operations (CFO)
- Relating to most income statement activities
- essential to the long-term viability of the company
- Excludes gains and losses--result from financing and investing activities
What activities are included under GAAP as useful for valuing equity but are excluded as useful for valuing the firm?
- Cash received from interest--CFI
- Cash received from dividends--CFI
- Cash paid for interest--CFF
Define cash flows from investing activities (CFI)
- Arise from the purchase and sale of noncurrent assets
- Currents assets are sometimes included if they are non-operating accounts (Example: short-term investments in securities)
Define cash flows from financing activities (CFF)
Arising from the issuance and retirement of interest-bearing debt, issuance and buybacks of stock, and dividend payments
What is the free cash flow formula and modified free cash flow formula?
FCF = CFO - Net Capital Expenditures (CFI) <--useful for valuation of equity
- FCF' = CFO' - CFI' <-- useful for valuing the firm
- calculate CFI' by adding back cash collected for interest and subtracting cash paid for interest.
- Adjust CFO' accordingly as well.
What is the indirect method?
- More common method
- Starts with net income and adjusts for accruals and deferrals (example: add back depreciation expense)
What is the direct method?
- FASB recommended format
- More informative
- each line item on the income statement is converted to a cash basis
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