Cash Flow Multipliers and Optimal Investment Decisions

Valuation multipliers are frequently used in practice. By postulating a simple stochastic process for the firm's cash flows in which the drift and the variance of the process depend on the investment policy, we develop a stylized model that links the cash flow multiplier to the optimal investment policy. Our model implies that the multiplier increases with investment at a decreasing rate. On the other hand, the multiplier is inversely related to discount rates. Using an extensive data set we examine the implications of our model. We find strong support for the variables postulated by the model