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The IUP Journal of Applied Finance
Potential Dividends Versus Actual Cash Flows in Firm Valuation
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Practitioners and a few academics use potential dividends rather than actual payments to shareholders for valuing a firm's equity. The paper underlines the differences between the two methods and presents some arguments supporting the thesis that firm valuation with potential dividends overstates the actual value of the firm's equity. In particular, consistent with DeAngelo and DeAngelo (2006 and 2007), the paper underlines that cash flows create value for shareholders only if they are withdrawn from the firm, and that the use of potential dividends may lead to contradictions.

 
 
 

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).

 
 
 

Applied Finance Journal, Cash Flow to Equity, CFE, Net Present Value, NPV, Net Fixed Assets, NFA, Working Capital, WC, Cash Flow, Funds Flow, Capital Asset Pricing Model, CAPM, Potential Dividends, Free Cash Flow, FCF, Operating Net Working Capital, Decision Making, Economic Value Added , EVA.