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

Ignacio Velez-Pareja () and Carlo Alberto Magni

No 4520, Proyecciones Financieras y Valoración from Master Consultores

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.

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. (search for similar items in EconPapers)
JEL-codes: G12 G31 M21 M40 M41 (search for similar items in EconPapers)
Pages: 27
Date: 2008-02-17
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Persistent link: https://EconPapers.repec.org/RePEc:col:000463:004520

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