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Potential Dividends and Actual Cash Flows. Theoretical and Empirical Reasons for Using 'Actual' and Dismissing 'Potential'. Or: How Not to Pull Pot..

Author

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  • Ignacio Velez-Pareja
  • Carlo Alberto Magni

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.

Suggested Citation

  • Ignacio Velez-Pareja & Carlo Alberto Magni, 2008. "Potential Dividends and Actual Cash Flows. Theoretical and Empirical Reasons for Using 'Actual' and Dismissing 'Potential'. Or: How Not to Pull Pot..," Proyecciones Financieras y Valoración 4520, Master Consultores.
    • Handle: RePEc:col:000463:004520
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    More about this item

    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.;
    All these keywords.

    JEL classification:

    • M21 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Economics - - - Business Economics
    • M40 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - General
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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