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Potential dividends versus actual cash flows in firm valuation

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  • Magni, Carlo Alberto
  • Vélez-Pareja, Ignacio

Abstract

Practitioners and some academics use potential dividends rather than actual payments to shareholders for valuing a firm’s equity. We underline the differences between the two methods and present some arguments supporting the thesis that firm valuation with potential dividends overstate the actual value of the firm’s equity. In particular, consistently with DeAngelo and DeAngelo (2006, 2007), we underline that cash flows create value for shareholders only if they are withdrawn from the firm, and that the use of potential dividends may lead to contradictions.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 is a modified version of the theoretical part (sections 1-3) of Velez-Pareja, I., and Magni, C.A. (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.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 14509.

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Date of creation: 09 Mar 2009
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Handle: RePEc:pra:mprapa:14509

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Keywords: Cash flows; cash flow to equity; liquid assets; potential dividends; firm valuation; equity value; Modigliani and Miller;

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  1. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, American Economic Association, vol. 76(2), pages 323-29, May.
  2. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(4), pages 305-360, October.
  3. Varian, Hal R, 1987. "The Arbitrage Principle in Financial Economics," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 1(2), pages 55-72, Fall.
  4. Harry DeAngelo & Linda DeAngelo, 2007. "Payout Policy Pedagogy: What Matters and Why," European Financial Management, European Financial Management Association, European Financial Management Association, vol. 13(1), pages 11-27.
  5. DeAngelo, Harry & DeAngelo, Linda, 2006. "The irrelevance of the MM dividend irrelevance theorem," Journal of Financial Economics, Elsevier, Elsevier, vol. 79(2), pages 293-315, February.
  6. Magni, Carlo Alberto, 2007. "Relevance or irrelevance of retention for dividend policy irrelevance," MPRA Paper 5591, University Library of Munich, Germany.
  7. James E. Smith & Robert F. Nau, 1995. "Valuing Risky Projects: Option Pricing Theory and Decision Analysis," Management Science, INFORMS, INFORMS, vol. 41(5), pages 795-816, May.
  8. Richard S Ruback, 2002. "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management, Financial Management Association, Financial Management Association, vol. 31(2), Summer.
  9. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 34, pages 411.
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