This paper supports the idea that potential dividends that are not distributed (and are
invested in liquid assets) should be ignored in firm valuation, because only distributed cash flows
add value to shareholders. Hence, the definition of Cash Flow to Equity (CFE) should
include only the cash flow that goes to the shareholders (dividends paid plus share repurchases
minus new equity investment). Although some authors warn against the use of potential
dividends in valuing firms (Vélez-Pareja, 1999a, 1999b, 2004, 2005a and 2005b; Fernández, 2002
and 2007; Tham and Vélez-Pareja, 2004; and DeAngelo and DeAngelo, 2006 and 2007), a
few others such as Copeland et al., 1994 and 2000; Benninga and Sarig, 1997; Damodaran,
1999 and 2006a; and Brealey and Myers,
2003) and many practitioners seem to support the
idea that CFE should include undistributed potential dividends, i.e., excess cash.
Inclusion of undistributed potential dividends in valuation is admissible if two
hypotheses hold: (1) excess cash is expected to be invested in zero-Net Present Value (NPV)
activities; and (2) all the cash from such investments is distributed, sooner or later, to the
shareholders. If these two assumptions hold, then potential dividends could safely be used for valuing
firms, because they would be value-neutral (DeAngelo and DeAngelo, 2006; and Magni, 2007).
But it should be noted that the definition of CFE is meant to be valid for all possible cases,
and thus, should not depend on a particular assumption about investment in liquid
assets; otherwise, the consequent definition of firm value
will also depend on that particular assumption. Furthermore, these assumptions disregard Jensen's (1986) agency theory: if
agency problems are present, managers tend to retain funds and invest them in
negative-NPV projects, which implies that dividend irrelevance does not apply any more. DeAngelo
and DeAngelo (2006), referring to Miller and Modigliani (henceforth MM) (1961), claim
that, "When MM's assumptions are relaxed to allow retention, payout policy matters in
exactly the same sense that investment policy does" (p.
293), and "irrelevance fails because
some feasible payout policies do not distribute the full present value of FCF to currently
outstanding shares" (p. 294). |