Potential dividends versus actual cash flows in firm valuation



I read the joint paper of Ignacio Velez-Pareja (IVP) with CA Magni, Potential Dividends vs Actual Cash Flows in Firm Valuation.

My comments:

There are no examples shown by authors how to get Actual Cash Flows…as this is about Forecast then there is such thing called Actual.

Probably what I capture from this paper. The authors want that the investment policy and payout policy for the excess cash is explicitly spelled out. Instead of assuming all Excess Cash be distributed as dividends.

The investment policy for excess cash will have the same impact as all distributed as dividends if the excess cash be put into zero NPV activities. For this statement. I am not really clear since in many valuation exercises during forecast mostly return is higher that WACC (abnormal then slowing down to normal or competitive margin).

Zero NPV activities also raise a question..as it is hard to imagine the company want to invest in such thing.

Excess cash in many cash be retained for “temporary” reason, for example, in Apple, to anticipate legal claims, to execute Acquisition, etc. Ultimately, it will go down to shareholders..this could be seen in Microsoft and Apple cases.

Excess cash should not be a norm in many companies. It could be high in certain period if there is a potential liquidity crises in financial market as management decides to keep the excess cash for a time being until the threat is lifted out.

As forecast is for long term view. Will this potential cash flow vs actual one will be a big difference to valuation? Or the error of not doing will have big impact? To answer this. Again I don’t see any example in numbers be shown by the authors.




The idea of that paper on potential dividends is simply that when calculating CFs you should take into account working capital including cash in hand and excess cash as ST investments if any.



I guess excess cash is not a spontaneous one, like Trade receivables or any operating cash.  This is a discretionary element. If it is considered too big, management could distribute it by increasing the payout ratio.




Yes, it can. But I wonder if you as analyst should decide that. It is a decision of the board of directors. 

If you are an analyst and forecast the CFs probably you don’t acummulate cash permanently. Hence, in general, cash and ST investments shoud be included in the working capital and forget the idea promoted by Damodaran of Potential Dividends.

When forecasting you can (as I do in my model) define a cash hold policy, a distribution policy (payment of dividends or Net Income), and a mechanism (see module 5 in our model) of investing temporary any excess cash that could be found. The policy IS NOT or SHOULD NOT to accumulate cash, in general. In any case, if the firm decides to hold cash it is a decision that destroys value and should be reflected in the CFs and hence in Value. 

In the model we have 5 modules: 

Module 1. Operating income and expenses

Module 2. Investment module

Module 3 Financing module: defines amounts of debt to be taken and payments of principal and interest

Module 4 Equity module:  amount od equity to be invested by owners and dividends payments

Module 5 Excess cash definition.

In Mod 3 and 4 we define the size of the deficit and we increase it by the amount of cash in hand, otherwise, your minimum end cash would be zero. Mod 5 defines if there is superavit that is decreased by the minimum cash desired. Otherwise the minimun cash in hand would be zero.

Minimum cash is defined by policy. The greater the cash in hand, the lower firm value. Defining the level of cash should be an issue to be formally studied. You can explore the firm history to see what final cash is compared, say with revenues or with expenses and based on that you define the policy as a % of one of them



Including excess cash into working capital movement comes with a cost. The amount of working capital then doesn’t make sense anymore…too big?

About the BOD (Board of Directors)’s decision, the shareholders could push the BOD to distribute the excess cash in dividends or share buy-backs. Remember FCF theory behind Acquisitions and Buy-outs in mid 1980s. The company holds too much cash.

Anyway, the issue is how to determine the elements of unlevered cash flows generated by the project, assuming that the project is financed entirely by equity.

Is excess cash of part of that?

Seems so..if this is generated by Operating Assets entirely.



Yes, few months ago I sent the complete model.

Except ST debt, you can model the project with 100% equity and this yields zero LT debt in Module 3. If you wish not to include ST, I will have to double check the model. I have to try it.

The behavior of the model is that when there is debt, then no excess cash to invest. It would make no sense to invest excess cash while paying interest on debt.



In reality, there is a cash called compensating balance in which company keeps paying interest on debt while keeping deposit in the same bank. Or, a company has a borrowing facility with a bank which loan facility requires the borrower to have their cash management be handled by the same bank lender, which means the borrower has to keep their current account and any excess money with the same bank.

So this is not uncommon thing.




Yes, that could be a condition from the bank. However, if the bank requires the same amount as collateral it makes no sense to borrow money from it.




November 2018



Posted in VALUATION.

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