Question

When debating the issue of whether to use free cash flows or earnings in a valuation model, economists sometimes argue that _________ can be subject to purposeful management by a firm and thus make them less useful

Answer 1

Economists prefer free cash flows over earnings for valuation because earnings can be manipulated through accounting, whereas free cash flows are a direct measure of the company's generated cash.

Step-by-step explanation:

When debating the issue of whether to use free cash flows or earnings in a valuation model, economists sometimes argue that earnings can be subject to purposeful management by a firm and thus make them less useful.

Earnings can be manipulated through various accounting practices, which might not reflect the true economic performance of the company. In contrast, free cash flows provide a more direct measure of the cash that a company generates, which is less susceptible to manipulation.

Companies have to choose how to access financial capital, which can affect their cash flow and earnings. Issuing bonds includes commitments to scheduled interest payments affecting free cash flow, while issuing stock means sharing ownership and control but not necessarily affecting cash flows.