Question

An analyst has computed a ratio of firm value (which he has defined as the mar-...

An analyst has computed a ratio of firm value (which he has defined as the mar-

ket value of equity plus long-term debt minus cash) to earnings after all interest

expenses and taxes.

a. Explain why this ratio is not consistently estimated.

b. Explain why this might be a problem when comparing firms using this multiple.

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Answer #1

a. Explain why this ratio is not consistently estimated.

The market value of equity would change frequently and drastically with change in economic/political and other considerations. Hence, consistency will not be there.

b. Explain why this might be a problem when comparing firms using this multiple.

The values used are:

*the market value of equity plus long-term debt minus cash, and

*earnings after all interest expenses and taxes.

The two quantities are not relevant to each other, because the earnings portion is after interest and taxes which is net income to equity and the capital employed includes long term debt.

While comparing different firms, the proportion of debt in the CS would vary with each firm's financial policy and hence would render the comparison defective.

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