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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 potential rabbits out of actual hats

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Author Info
Vélez-Pareja, Ignacio
Magni, Carlo Alberto

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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.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 7266.

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Date of creation: 19 Feb 2008
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Handle: RePEc:pra:mprapa:7266

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Related research
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

Find related papers by JEL classification:
M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy
G30 - Financial Economics - - Corporate Finance and Governance - - - General
M40 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - General
M21 - Business Administration and Business Economics; Marketing; Accounting - - Business Economics - - - Business Economics

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Lee Pinkowitz & Rene M. Stulz & Rohan Williamson, 2003. "Do Firms in Countries with Poor Protection of Investor Rights Hold More Cash?," NBER Working Papers 10188, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. DeAngelo, Harry & DeAngelo, Linda, 2006. "The irrelevance of the MM dividend irrelevance theorem," Journal of Financial Economics, Elsevier, vol. 79(2), pages 293-315, February. [Downloadable!] (restricted)
  3. Richard S Ruback, 2002. "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management, Financial Management Association, vol. 31(2), Summer.
  4. Varian, Hal R, 1987. "The Arbitrage Principle in Financial Economics," Journal of Economic Perspectives, American Economic Association, vol. 1(2), pages 55-72, Fall. [Downloadable!] (restricted)
  5. Magni, Carlo Alberto, 2007. "Relevance or irrelevance of retention for dividend policy irrelevance," MPRA Paper 5591, University Library of Munich, Germany. [Downloadable!]
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