Potential dividends and actual cash flows. Theoretical and empirical reasons for using ‘actual’ and dismissing ‘potential’, Or: How not to pull potential rabbits out of actual hats

Vélez-Pareja, Ignacio and Magni, Carlo Alberto (2008): Potential dividends and actual cash flows. Theoretical and empirical reasons for using ‘actual’ and dismissing ‘potential’, Or: How not to pull potential rabbits out of actual hats.

Abstract

Practitioners and academics in valuation include changes in liquid assets (potential dividends) in the cash flows. This widespread and wrong practice is inconsistent with basic finance theory. We present economic, theoretical, and empirical arguments to support the thesis. Economic arguments underline that only flows of cash should be considered for valuation; theoretical arguments show how potential dividends lead to contradiction and to arbitrage losses. Empirical arguments, from recent studies, suggest that investors discount potential dividends with high discount rates, which means that changes in liquid assets are not value drivers. Hence, when valuing cash flows, we should consider only actual payments.

• Item Type: MPRA Paper
• Language: English
• Keywords: Cash flows, cash flow to equity, free cash flow, liquid assets, potential dividends, firm value, equity value, Modigliani and Miller, levered value, error in valuation
• Subjects: M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M4 - Accounting and Auditing > M41 - Accounting; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; G - Financial Economics > G3 - Corporate Finance and Governance > G30 - General; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M4 - Accounting and Auditing > M40 - General; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M2 - Business Economics > M21 - Business Economics

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