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ONCE MORE, THE CORRECT DEFINITION FOR THE CASH FLOWS TO VALUE A FIRM (FREE CASH FLOW AND

CASH FLOW TO EQUITY)

Ignacio Vélez–Pareja Politécnico Grancolombiano Bogotá, Colombia ivelez@poligran.edu.co
I wish to thank the comments received from
Hugo Berlingeri (hugoberlin@uolsinectis.com.ar), Ricardo Botero (rbgstocks@hotmail.com), Edinson Caicedo (edcaiced@hotmail.com, edcaiced@univalle.edu.co), Juan Carlos Gutiérrez (juancg@proteccion.com.co) y Eduardo Petracca (epetracca@arnet.com.ar). Any mistake is my entire responsibility.

First version: January 3, 2004 This version: October 28, 2007

ABSTRACT This paper is an extension of a previous one untitled The Correct Definition for the Cash Flows to Value a Firm (Free Cash Flow and Cash Flow to Equity)1. We have added a comparative analysis between the current practice of including as cash flows amounts that belong to the Balance Sheet and the proposed approach to include only as cash flows those elements that in fact are cash flows and hence are not listed in the Balance Sheet. Differences are significant. Surprisingly there is a wide range of interpretations on how to calculate the cash flows for valuation purposes. This ample definition of what the cash flows are is shared by academicians and practitioners. Some of the definitions openly contradict the essential and basic concepts of cash flow and time value of money. In this note we specify very clearly what has to be included in those cash flows and the reasons why they should be included. The main issue is related to the inclusion or exclusion of some items in the working capital and the current practice to consider that funds that appear in the Balance Sheet (cash and market securities and the like) belong to the free cash flow FCF and the cash flow to equity CFE. In the same line of reasoning, the idea is that cash flows have to be consistent with financial statements. With a hypothetical example we show the implicit financial facts reflected in the financial statements behind the practice of including as cash flow items that appear in the Balance Sheet.

KEY WORDS Cash flows, free cash flow, cash flow to equity, valuation, levered value, levered equity value, cash budget. JEL CLASSIFICATION M21, M40, M46, M41, G12, G31, J33

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Available at www.ssrn.com

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Differences are significant. This ample definition of what the cash flows are is shared by academicians and practitioners. Some of the definitions openly contradict the essential and basic concepts of cash flow and time value of money.ssrn. The main issue is related to the inclusion or exclusion of some items in the working capital and the current practice to consider that funds that appear in the Balance Sheet (cash and market securities and the like) belong to the free cash flow FCF and the cash flow to equity CFE. In the same line of reasoning. THE CORRECT DEFINITION FOR THE CASH FLOWS TO VALUE A FIRM (FREE CASH FLOW AND CASH FLOW TO EQUITY) INTRODUCTION This paper is an extension of a previous one untitled The Correct Definition for the Cash Flows to Value a Firm (Free Cash Flow and Cash Flow to Equity)2.com 3 . With a hypothetical example we show the implicit financial facts 2 Available at www. In this note we specify very clearly what has to be included in those cash flows and the reasons why they should be included. We have added a comparative analysis between the current practice of including as cash flows amounts that belong to the Balance Sheet and the proposed approach to include only as cash flows those elements that in fact are cash flows and hence are not listed in the Balance Sheet.ONCE MORE. the idea is that cash flows have to be consistent with financial statements. Surprisingly there is a wide range of interpretations on how to calculate the cash flows for valuation purposes.

6 Our position is very simple: cash flow implies movement of cash (except when we consider the opportunity cost of some asset and then we include that value as a cash flow) hence funds tied to the balance sheet cannot be considered a cash flow.5 On the other hand. et al.4 and Damodaran) support the idea that the CFE has to include potential dividends. Benninga et al. 5 Professor Tom Copeland in a private correspondence says: “If funds are kept within the firm you still own them -. 1999. Hence. Vélez-Pareja (1994. When the firms are traded. using arbitrage arguments. 4 Benninga says: […] Free Cash Flow (FCF) a concept that defines the amount of cash that the firm can distribute to security holders.hence "potential dividends" are cash flow available to shareholders. 2004) and Tham y Vélez-Pareja. he disregards those arguments and keep using the idea that CFE is what is available (even if it is not paid to the equity holder). 3 The cash budget is a financial statement where every inflow and outflow is listed and the difference is the period net cash flow. in some slides found at his website. 1997. excellent arguments to favor the idea that the CFE has to include just what the stockholders actually receive.reflected in the financial statements behind the practice of including as cash flow items that appear in the Balance Sheet. SOME CONSIDERATIONS REGARDING THE TYPICAL PRACTICE Some respected authors (Copeland. 2004 have insistently expressed the idea that the most straightforward approach to derive the cash flows is starting from the cash budget3. It is important to say that the context of this paper is for nontraded firms. it could be shown. and the assumptions of a perfect market are met. The accumulated balance resulting form the net cash flow has to match with the cash on hand found in the Balance Sheet. […] Cash and marketable securities are the best example of working capital items that we exclude from our definition of [change in net working capital] adjustment. the strict definition of CFE is dividends plus repurchase of stock and minus equity investment. whether or not they are paid out now or in the future. professor Damodaran has.” 6 See the transcription of the relevant slides in the Appendix 4 . however. that the value is the same if the firm distributes or not the cash excess.

about the irrelevance of dividends should deter that practice. If to estimate the cost of capital we depart from the betas found in the market. It is argued that when cash excess is invested in market securities. We never add to the dividends use to calculate the return of a stock the items in the balance sheet listed as cash in hand and marketable securities. 1961. When the CAPM is used to estimate the cost of equity.Some other arguments to reinforce this idea are: 1. More. This is not reasonable because precisely the beta coefficient captures the risk of paid dividends. CAPM. they capture the risk of the stock using paid dividends and the value the market assign to the stock discounting the future dividends. The use of potential dividends is in clear contradiction with the Capital Asset Pricing Model. 3. The same idea of Miller y Modigliani. and the dividends are a function of the net income. we use dividends paid. that includes the return received from those market securities investments. hence in the beta coefficient we are counting the larger or smaller risk associated to the market securities. then we are facing cash flows with net present value of zero because those flows are discounted at the same rate of return the securities earn. M&M. 2. To consider as cash flow items that are listed in the balance sheet is to deny the basic concept in valuation: the time value of money. we never use potential dividends. We discount cash flows when they are received. Even if dividends are not paid the value 5 . It is a contradiction to say that an item is at the same time a line in the balance sheet and a line in the cash flow. Ke.

that is not taxed in reality. Below we show what might happens in a simple example when the payout ratio is 100% and any excess cash is distributed instead of being invested in market securities. When including the excess cash invested in marketable securities and cash as part of the CFE we are distorting the taxes. For traded firms it is possible to use arbitrage arguments to show that it is the same to distribute or not the cash excess and even to invest them at higher or lower rates of return. Our position is that there should be a complete consistency between cash flows and financial statements.is captured in the terminal value. When we assume that some funds are invested at a rate that usually is lower than the discount rate. 5. Then it is not clear at all why we should insist on using as CF what it is not. 6 . TV. This is an old proposal from Lorie and Savage (see Lorie and Savage (1955)). Ke. then that fact should be reflected at the financial statement. Instead of generating an explicit return (usually very low) that is taxed in the income statement. we are assuming implicitly that those cash flows are reinvested at the same discount rate we use to discount them. If we say that every penny available belongs to the cash flow to the equity holder (CFE). we “generate” a virtual return at the cost of equity. This virtual or implicit return is one of the implicit assumptions when we discount cash flows. but those implicit returns never are taxed. for instance. and yet we incluye those funds in the cash flow. Here we understand as virtual return that return obtained implicitly when the cash flows are paid to the owners of the capital (euity or debt). 4. In fact we are.

the implicit assumption is that the equity holders invest the cash flows at their required cost of capital and it is not true because they have not received those funds. The value of the firm is in the cash flows that go out of it and not in the funds that remain within the firm. or the weighted average cost of capital (WACC). but they have not. be it debt or equity. (the funds are investid in market securities). When we add the cash in hand and the marketable securities listed in the balance sheet we are concealing a potential wrong financial management practice. If those funds are in the cash flows.Here it is important to say take into account the following: cash flows are what the firm pays to the owners of capital. the firm is worth because the capital owners withdraw funds from the firms. When those cash flows are in the hands of the equito or debt holders it is ASSUMED that they invest at their own required rate of returns (it is possible that they invest those cash flows in investment with higher rates than the required ones). It might sound as a paradox but. and when we discount the flows at the discount rate be it the cost of levered equity. This is to say that if we model a firm as we expect as it will happen in the future and if in that future it is expected that excess cash is invested and low rates (even at zero interest if the funds are kept at hand) and at the 7 . The outflows (the CFD and the CFE adjusted by tax savings) from the firm are the free cash flow! 6. it is “as if “ the equity holders have received them. The problem arises when THE FIRM DOES NOT PAY the cash flows to the equity holders the funds that are tied either to cash in hand or to market securities. Ke.

There is some empirical evidence that dividends and not cash in hand or invested in market securities is what increases firm value. 8 . Philippines. Data cover ten years with some exceptions such as India. The values in the table are the mean of the medians for each variable for each country. Cash and market securities and dividends. Market Value to Book Value (MV/BV) is the sum of market equity value plus book value of debt divided by book value of assets. We have run a simple linear regression between MV/BV. Williamson and Stulz.same time we include the invested funds in the CFE we are concealing a financial malpractice. Dividends and Cash and market securities is the percent of those items in the Balance Sheet on total assets. See table and statistical analysis below. Data from Pinkowitz. it would mean that it would be the same to have the excess cash invested at high or low rates. Turkey and Peru. In other words. (2007) present evidence of this fact.

967 Chile 0.893 Spain 0. Williamson and Stulz.046 Philippines 0. (2007) The regression with MV/BV as dependent variable and the other two variables as independent variables.026 1.889 Finland 0.897 Peru 0.821 Thailand 0.094 1.013 0.822 Greece 0.783 Malaysia 0. When the regression is run with only dividends and MV/BV the result is 9 .025 0.809 Brazil 0.006 0.047 0.972 Netherlands 0.055 1.007 0.014 0.024 0.013 0.Table 1a.008 0.014 Korea (South) 0.046 1.005 0.056 0.044 1.007 0.026 0.009 0.011 0.711 Germany 0.947 Italy 0. Dividends.004 0.01 0.089 0.014 0.969 Norway 0.024 0.763 Singapore 0.023 0.089 0.655 Japan 0.997 USA 0.014 0.029 0.056 0.039 0.808 Sweden 0.301 Ireland 0.076 1.108 0.389 UK 0.085 0.011 0.009 0.138 1.025 1.16 1.586 Canada 0.009 0.006 0.094 0.048 1.062 0.817 France 0.042 0.011 0.344 Mexico 0.769 Australia 0.015 0.003 0.08 0.014 0.092 0.044 1.861 Switzerland 0. Cash and market securities leaves the model for statistic significance.29 Portugal 0.013 0.025 0.048 0. Cash & market securities and MV/BV by country Country Dividends Cash MV/BV Argentina 0.138 0.065 0.151 Source: Pinkowitz.834 India 0.174 Turkey 0.009 0.813 New Zealand 0.066 0.013 0.758 Belgium 0.026 0.057 0.013 Austria 0.125 Denmark 0.164 Hong Kong 0.013 South Africa 0.021 0.064 0.008 0.014 0.045 0.119 0.102 0.037 1.

10 .Table 1b. cash in hand or invested in market securities do not increase the firm value. What increases that value is dividends paid to equity holders. CB statement.01806838 Critical value for F is 0. Two of these sections include the transactions with debt and equity holders. From there the CFE and the cash flow to debt.01806838 In other words. 7 This example is available directly from the author. Tham and Vélez-Pareja (2004) propose explicitly to include in the CFE only the cash that is received or distributed to the equity holder. (for instance. Coefficient and significance of MV/BV dependent variable Coefficients Probability Intercept 0. Would a financial analyst dare to present a financial model where equity becomes negative? We are sure she will not.97813497 0.83040682 4. In this financial statement they present four modules or sections. “Potential” dividends does not mean more value for equity holders although including them in the analysis as cash flows for valuation the resulting value is greater than when they are not included. CFD can be derived straightforward.7122E-16 Dividends 7. but titles are in Spanish. The approach departs from the cash budget. AN EXAMPLE7 This is an example where the book value leverage D% affects the growth of the firm and the accounts payable conditions. As can be seen below in a simple example. The financial statements and the cash flows are completely integrated. when total excess cash is distributed then initial equity could be reduced and eventually reach negative values. the average in the industry) the suppliers require payment more quickly and customers fear that the firm will not honor its delivery and might go to the competition). This allows the analyst to “see” what is going on. The higher the D% the lower the growth and the stringent accounts payable conditions (when D% is higher than a given value.

0 140.5 2.298.911.0 0.0 3.326.0 1.0 110.509.0 0.961.850.0 0.4 -1.5 4.326.7 0.386.4 987.534.1 22.326.9 3.547.534.2 3.971.156. Cash Budget.1 3.0 6.4 1.1 10.0 We have listed the taxes paid in order to compare how taxes change when one or another method is used.0 10.242.509.0 6.158.5 16.3 12.457.8 -16.5 0.461.0 120.0 130.585.5 0.881.0 3.0 6.7 19.154.8 0.4 0.0 3.642.0 0.585.9 1.414.741.784.0 5.6 3.326.9 7.0 3.840.0 0.326.4 100.3 12.0 0.992.7 1.683.2 6.003.4 3.955.0 1.585.0 10.0 29.161.6 -46.0 3.971.6 15.0 10.2 0.080.632.203.0 -20.253.906.632.5 5.9 0. We indicate the derivation of the CFE and the cost of equity.0 3.0 1.977.7 0.0 2.485.023.1 2.0 10.0 495.6 16.1 6.0 0.7 0.5 0.Next we show the Balance Sheet and the Cash Budget.0 0.0 121.268.0 5.0 0.465.0 -13.0 16.0 2.023.585.7 3.000. Now we show the Balance Sheet 11 .0 0. Table 2a.2 4.654.4 0.0 0.2 5.684.0 19.0 0.680.0 15.0 5.6 16.7 0.9 226.0 0.0 0.8 3.5 0. CB when payout ratio is 100% and any excess cash in invested in market securities.8 -38.026. as well. Ke.1 1.2 0. Year 0 Taxes Operating net cash flow Module 2: External financing Loan 1 LT Loan 3 LT Loan 2 ST Loan in foreign exchange Payment of loans Loan 1 LT Loan 3 LT Loan 2 ST Loan in foreign exchange Interest paid Net cash flow after financial transactions Module 3: Transactions with the equity holder Equity investment Payment of dividends Repurchase of shares Net cash flow after Transactions with the equity holder Module 4: Discretional transactions Market securities recovery Interest from market securities Investment in market securities Net cash flow after discretional transactions Net cash balance at the of year Year 1 Year 2 Year 3 Year 4 Year 5 0.

9 6.2 2.967.9 39.0 29.0 3.500.0 2.4 0.8 1.98% 0.4 4.840.3 15.0 0.8 35.738.585.0 5.250.636.5 51.137.8 6.265.293.0 6.0 0.109.5 2.678.156.0 25. 12 .228.0 3.5 22.0 0.4 45.979.511.4 68. Year 0 Year 1 100.6 10.0 1.164.000.83% Levered equity 21.0 33.3 10.840.112.0 0.0 Check From Module 3 at the CB we construct the CFE: Table 3.99% 16.Table 2b.4 15.377.0 0.96% 15.840.0 44.268.971. calculations not shown).9 0.0 0.0 2.92% 0.193.784.0 Payment of dividends 0.643.7 Repurchase of shares 0.750.0 2.000.0 CFE 0.0 CFE with TV for CFE 0.000.968.0 60.90% 17.287.144.440.840.0 226.8 0.156.0 33.268.0 0.0 0.9 48.268.0 2.3 0.0 2.5 2.7 16.4 0.1 0.8 33.9 16.0 4.0 2.617.0 0.937.534.0 2.653.7 11.7 TV − debt 32.2 54.0 0.293.2 60.268.000.0 226.7 33.1 13.0 40.0 226.871.860.506.2 4.0 28. CFE with 100% payout reinvestment of excess cash in market securities Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Equity investment 0.0 Year 2 110.777.0 3.0 48.9 2.678.0 0.9 13.0 2.311.65% 0.156.793.497.09% 0.6 3.6 19.0 Year 3 120.0 6.342.9 0.717.294.2 4.777.000.0 2.5 23.0 44.7 2.8 38.70% 16.1 7.156.005.0 48.0 4.7 Ke 19.425.690.0 0.1 24.310.514.9 15.4 23.0 0.0 56.988.094.3 9.955.967.265.0 Year 5 140. BS when payout ratio is 100% and any excess cash is invested in market securities.0 2. Balance Sheet.7 61.1 12.0 29.0 2.9 48.18% 0.377.5 15.0 Assets Cash on hand Accounts receivable Inventory Market securities Current assets Net fixed assets Total Liabilities and equity Accounts payable Short term debt ST Current liabilities Debt in domestic currency Debt in foreign currency Total Liabilities Equity Retained earnings Total D% (book value) 1.0 35.3 15.849.828.2 40.0 2.952.514.680.632.632.0 Year 4 130.2 2.835.2 1.000.306.2 4.000.265.8 6.0 226.367.0 5.00% 0.005.509.0 0.6 2.2 61.0 16.7 38.7 17.055.738.3 42.9 32.0 2.5 Observe that the CFE is derived directly from Module 3 in the CB (except the terminal value at year 5 and Ke.690.265.699.916.0 15.

3.683.0 16.949.0 0.556.0 0.5 0.0 0.0 0.242.2 0.3 -46.1 3.326.6 in the first case.150.326.0 1.0 0.4 -1.1 0.745.0 0.6 15. 4 and 5 are 2.0 5.7 15.1 3.4 -1.0 0.0 0.9 8.0 0.7 0.0 3.939.457.839.684.0 0.The values for equity and firm (calculation not shown) are: equity value is 21.0 6.0 0.0 0.0 3.326.0 0.465.0 0.0 0. taxes for years 3.5 6. 3.0 0.8 3.0 0.0 Observe the taxes paid in this case and in the previous one.881.0 0.0 y 1.042.023.0 121.5 0.5 0.326.0 3.3 1. Table 4. This indicates a very important variation in taxes.0 0.000.0 2.5 9.0 3. in the second case they are 1.627.585.5 0.0 0. Cash Budget.0 0.609.880.0 -13.0 6.9 17.585.0 1.0 0.0 3.198.051.0 0.374.0 0.4 0.834.446.627. CB when layout ratio is 100% and any excess cash is paid to the equity holder.0 0.6.5 0.654.0 226.4 0.0 0.2 6.8 3.5 3.547.0 0.252.4 that is equal to equity value plus debt.086.298.0 3.0 20.0 0.0 3.7 0.5 0.0 0.939.414.9 3.2 5.7 987.2 6.7 3. For instante.2 0.0 and firm value is 54.1.784.326.680.109.0 1.1 5.376.585.9 3. Year 0 Taxes Operating net cash flow Module 2: External financing Loan 1 LT Loan 3 LT Loan 2 ST Loan in foreign exchange Payment of loans Loan 1 LT Loan 3 LT Loan 2 ST Loan in foreign exchange Interest paid Net cash flow after financial transactions Module 3: Transactions with the equity holder Equity investment Payment of dividends Repurchase of shares Net cash flow after Transactions with the equity holder Module 4: Discretional transactions Market securities recovery Interest from market securities Investment in market securities Net cash flow after discretional transactions Net cash balance at the of year Year 1 Year 2 Year 3 Year 4 Year 5 0.5 16.0 0.198.479.0 14.0 49.0 0.154.632.446.4 1.433.3 respectively.953.5 y 2.585.0 0.9 1.7 1.0 6.632.0 0.953.003. Next we show the Balance Sheet 13 .0 0.585.6 -38.

0 0.3 6.9 3.2 47.4 0.56% 14.3 16.3 0.92% 71.9 0.835.186.560.0 10.7 13. CFE with 100% payout total distribution of excess to equity holders Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Equity investment 0.643.65% 15.4 38.2 -4.2 3.250.8 16.511.0 0.95% 92.0 Ke 15.0 22.0 0.6 14.4 29.252.094.9 0.7 0.000.777.620. we construct the next table to derive the CFE: Table 6.0 4.16% 75.0 0.5 9.0 2.0 3.313.7 Year 2 0.2 Repurchase of shares 6.8 1.7 Year 4 0. BS when payout ratio is 100% and any excess cash is paid to the equity holder Year 0 Year 1 0.3 Assets Cash on hand Accounts receivable Inventory Market securities Current assets Net fixed assets Total Liabilities and equity Accounts payable Short term debt ST Current liabilities Debt in domestic currency Debt in foreign currency Total Liabilities Equity Retained earnings Total D% (book value) 1.191.0 Check Observe the net equity in the Balance Sheet.479.0 1.376.0 2.144.0 59.0 0.699.7 61.5 19.8 CFE with TV for CFE 6.395.265.3 6. Balance Sheet.9 3.4 38.68% 0.1 5.0 5.1 0.7 27.0 8.128.063.3 6.834.4 49.632.012.720.440.4 5.678.865.0 16.4 15.9 2.0 3.0 0.2 42.784.9 2.609.7 226.0 3.211.2 3.0 0.560.7 0.0 0.0 48.0 Year 5 0.680.777.1 53.2 6.678.0 56.632.9 2.0 5.143.1 5.2 2.1 17.5 6.086.865.3 9.0 2.627.0 0.0 1.7 27.390.686.500.010.609.609.916.8 22.1 6.7 61.627.5 8.211.633.150.377.0 2.741.367.4 1.1 -4.367.0 33.834.137.939.2 0.0 2.10% 15. When cash flows are calculated using the traditional approach.228.1 0.5 39.0 0.0 2.Table 5.055.240.939.265.750.6 2.617.193.01% Levered equity 24.514.265.653.378.9 2.0 5.979.012.0 2.627.514.937.0 0.0 0.294.0 14 .10% 14.0 16.0 33.5 8.0 2.2 68.0 11.265.012.9 0.627.306.0 0.311.828.2 47.9 23.128.0 226.6 2.056.7 15.0 7.0 Payment of dividends 0.313.000.6 0.0 0.711.0 CFE 6.585.560.425.36% 96.0 0.4 45.0 4.071.79% 85. the analyst do not even realize Chat is going on! Who dares to submit a financial statement like this one? From Module 3 in the CB.0 2.5 2.2 TV − debt 11.377.796.8 16.7 13.9 48.8 Year 3 0.0 3.0 0.086.4 -4.6 2.939.376.

that cash is held in the bank and there is investment in market securities. observe that the CFE is derived directly from Module 3 in the CB (except the terminal value at year 5 and Ke. Then we can say that equity is in fact negative for the last 3 years. 15 .276.1 and it is equal to equity value plus debt.010. Values for equity and firm (the calculation is not shown) are: equity value is 24. The sum of the 2 items is positive in some years. Now we will examine what occurs when the common practice is used. Now we calculate the cash flows from the Income Statement and cash in hand and market securities will not be included in the working capital.Again. 57. and it is assumed that all excess cash is distributed. the analyst does not even realize what is happening with the equity in the Balance Sheet. this is. but we have to pay the retained earnings just the next year. Equity has been reduced steadily from year 1 to year 5.8 and firm value. We are sure that no analyst will dare to present a business plan or forecasted financial statements with the behavior for the equity as it is shown in this example. calculating the cash flows from the Income Statement and not including the cash in hand and the market securities in the working capital. calculations not shown). Observe the BS and look at the equity and retained earnings together. The relevant issue here is that when the FCF or the CFE is derived from the Income Statement and the Balance Sheet. that is. As a first step we calculate the working capital without including the cash in hand and the market securities and assuming that the financial statement do not reflects the fact that all the cash excess is distributed.

5 2.741.0 0.4 196.9 58.289.377.1 -3.590.3 Tax savings (TS = T × Interest) 1.0 2.2 82.7 Capital Cash Flow CCF = FCF + TS 15.2 Now we calculate the FCF and the CFE departing from the Income Statement.250.461.156.063.2 FCF -45.208.0 17.250.000.0 2.741.680.048.678.955.9 -2.8 -1.7 14.124.1 22.367.554.8% 16.143.4 41.8 1.3 2.6 Year 3 2.918.0 4.4 0.8 Ke 19.807.0 11.1 4.0 0.0 0.850.250.289.662.0 0.0 11.8 1. Table 8: Calculation of cash flows and value (cash excess invested) Year 0 Year 1 Year 2 Year 3 Year 4 Earnings Before Taxes and Interest (EBIT) 0.3 -204.6 Firm value = FV 56.711.6 16.165.0 2.731.0 11.0 0. 16 .9 Equity value (FV − debt) 23.954.0 204.5 8.3 1.7 Depreciation 0.629.1 40.254.2 1.188.3 -3.6 2.507.617.0 1.440.0 2.8 320.3 8.680.228.781.094.245.8 30.075.0 0.1 24.8 Year 2 2.0 0.0 0.6 TV (calculation not shown) CCF + TV 15. no investment in market securities.514.378.9 2.1 16.0 4.202.2 0.3 20.036.9 4.5% 18.3 35.8 16.294.178.000.055.3 -37.835.181.7 2.0 1.804.023.0 -1.Table 7: Calculation of the change in working capital (cash excess invested) Accounts receivable Inventory Current assets Accounts payable Short term debt Unpaid taxes Current liabilities Working capital Change in Working capital Year 0 0.3% 17.6 -188.2 6.252.9 2.9 5.311.0 2.5 49.605.0 0.425.4 Year 5 10.355.3 Year 4 3.777.086.0 -320.7 2.0 -2.254.8 2.197.3 1.5 848.9 0.461.6 5.3 0.000.680.0 2.0 0.376.871.8 Taxes on EBIT 0.138.7 188.777.1 -38.0 2.193.066.0 0.0 Year 1 2.0 0.6 10.540.678.2 897.9 6.0 22.0 11.377.9% Equity value 23.1 5.8 16.916.0 2.654.3 72.250.0 1.489.3 Minus investment -45. 8 CFD is derived from module 2 in the CB.0 17.0 13.6 16.2 583.941.0 Minus change in working capital 0.385.8 -196.252.937.719.514.3 -37.1 CFE = FCF + TS − CFD8 5.540.228.3 Year 5 3.4 15.0 0.7% Now we calculate the same items calculated above but assuming that the financial statements reflect the fact that all the available cash is distributed: nothing left as cash in hand.720.0 -56.3 2.9 -16.

1 5.0 0.188.1 24.8 320.4 196.0 1.0 -45.4% 20.250.954.804.0 44.228.479.178.3 0.063.124.5 0.0 204.514. 17 . except for year 0).0 0.0 15.0 -45.3 0.916.075.3 11.6 Year 3 2.6 2.143.937.0 2.265.9 5.168.377.094.000.6 15.355.7 -37.6 -2.3 34.252.680.629.850.5 25.7 3.1 4.507.9 2.3 Year 4 3.243.6 76.6 -37.3 -56.9 2.3 583.0 0.425.3 2.197.878.731. now we calculate the FCF and the CFE departing from the Income Statement.627. now they are at zero.935.2 87.3 Year 5 3.0 2.0 0.0 0.0 0.8 -3.285.0 0.7 2.0 0.000.9 11.376.680.377.048.0 1.0 2.311.8 Year 4 10.3 57.0 9.0 2.674.425.3 Year 5 10.654.7 14.801.1% 25.4 5.617.254.147.2 6.250.0 1.1 -3.0 11.0 Year 3 8.6 0.3 -2.9 2.0 -196.252.777.5 17.0 13.678.2 16.0 2.8 Year 2 2.0 -320.0 -204.193.0 0.6 59.0 0.540.3% 25.3 6.5 21.000.9% 24.0 0.1 897.678.0 -188.143.1 9 CFD is derived from module 2 in the CB.0 2.6 5.378.461.8 2.675.9 6.440.8 0.254.367.4% 19.395.8 1.590.896.250.055.0 16.9 4.086.3 As before.826.3 Year 2 6.6 52.0 2.662.8 8.777.3 2.529.2 -38. Table 10: Calculation of cash flows and value (cash excess not invested) Year 0 Earnings Before Taxes and Interest (EBIT) Taxes on EBIT Depreciation Minus change in working capital Minus investment FCF Tax savings (TS = T × Interest) Capital Cash Flow CCF = FCF + TS TV (calculation not shown) CCF + TV Firm value = FV Equity value (FV − debt) CFE = FCF + TS − CFD9 Ke Equity value 0.2 -1.720.7 2.3 15.835.039.711.0 27.682.4 1.294.2 17.7 188.7 11.385.781.0 Year 1 2.0 Year 1 4.250.540.3 -6.0 2.5 2.0 16.0 0.3 0.023.4 29.8 1.9 17.165.3 17.0 0.461.9 0.052.680.9 19.265. Table 9: Calculation of the change in working capital (cash excess not invested) Year 0 Accounts receivable Inventory Current assets Accounts payable Short term debt Unpaid taxes Current liabilities Working capital Change in Working capital 0.7 -3.878.514.In the same manner we calculate the cash flows from the Income Statement and working capital will not include cash in hand nor market securities (in fact.1 16.

4 0.374.0 57. In the same way.289. Table 12: Differences against proponed approach to calculate cash flows (shaded cells) Firm value Valor del patrimonio Valor de la Valor del firma con la patrimonio con la práctica práctica corriente 56.12% 3.75% 59. Table 11: Differences between methods Firm value Equity value Firm value Equity value Difference Difference using qith current in firm in equity current practice value value practice 56.33% 59.143.1 5.34% 24.1 4.Now we can compare the different results.5 23.0 0.4 21.5 23.1 11.33% With cash excess invested All cash excess is distributed and reflected in the financial statements Difference 54.289.5 8.878.374.5 4.1 4.01% 10.75% In tables 11 and 12 we can observe that the differences when calculating cash flows according to the current practice against to calculate the value based on the actual cash that is listed as a cash movement (not potential dividends.34% 21.26% 7. we compare the values calculated according the common practice of not including cash and market securities in the working capital against the proposed approaches (columns 4 and 5 against columns 2 and 3).109.1 22.8 13.01% 10.878.78% Now we compare all the values obtained with the value calculated making explicit the investment of the excess cash and listing as a cash flow only what the equity and debt holders effectively receive.109.59% With cash excess invested All cash excess is distributed and reflected in the financial statements 54.554.00% 57.276. (and this is what finally we are 18 . We take as reference the firm and equity values calculated when excess cash is invested in all cases (second line versus first line).010.554. for instance) are relevant.77% 25.00% 24.276.8 13.1 5.010.143.58% 25. mainly when we observe the amounts related to the equity value.

Corporate Finance. they belong to the BS. and Corporate Governance: A Cross-Country Analysis. 3rd Edition. 2nd Edition. E. Octubre. Three Problems in Rationing Capital. 1959. McGraw-Hill. 34. J.77%.01% and 8. BIBLIOGRAPHIC REFERENCES Benninga. The Free Press of Glencoe. Stulz. Dividend Policy. T. in the case of equity differences are 10. These differences are significant. John Wiley & Sons1995. the financial statements show how that practice distorts the financial statements and in many cases the analyst do not even realize what is happening with the financial statements. J. Growth and the Valuation of Shares. Savage... The Management of Corporate Capital. Simon Z. 2004 Lorie.edu/~adamodar/pdfiles/eqnotes/packet1.33% and 22. CONCLUDING REMARKS We have shown some arguments against the current practice of including in the CFE items that are not cash flows. Vol. J. T. the equity value. We have shown with a simple example what might happen when the payout ratio is 100% and when all the excess cash is distributed to the equity holder. Valuation: Measuring and Managing the Value of Companies. In fact. The Journal of Business. Modigliani. A Valuation Approach. Koller. Lee. 1997 Copeland.pdf visited on May. Sarig. Winter. that fact should be reflected in the financial statements. and Murrin. John Wiley & Sons. In that case.stern. Vol. Journal of Applied Corporate Finance.59%. Thomas E. 411-433 (Oct). P. In summary: the CFE should reflect exactly what is paid to the equity holders. No.. y L. In case that it is decided to distribute all the available cash. and Oded H. 4. 2000 (July 28). (Ed). Aswath www. XXVIII. Journal of Business. and Murrin. J. Valuation: Measuring and Managing the Value of Companies. Cash Holdings. Miller. 1961. 2007.. H. Koller. V. Rohan Williamson and René M. Pinkowitz. 19 . 19 N. Dividend Policy. 1955. Thomas E. Illinois.looking for) In the case of the firm value these differences are 4. we have shown how when considering amounts that are not cash flows we overvalue the firm value and specially. On the other hand. M.nyu. 1. En Solomon. Damodaran. y F. Copeland. H.

CEJA. Ignacio. 2004. 4ed 2004. Vélez-Pareja. Colombia. I. Ignacio. Decisiones de Inversión. Decisiones de Inversión. Decisiones de Inversión. 1994. 20 . Part I" (December 1999). Evaluación Financiera de Proyectos de Inversión. Enfocado a la Valoración de Empresas. "Construction of Free Cash Flows: A Pedagogical Note. Vélez-Pareja. and Vélez-Pareja. J. CEJA. Academic Press. CEJA. http://ssrn. una aproximación al análisis de alternativas (Versión preliminar). Ministerio de Trabajo y Seguridad Social. Vélez-Pareja. Principles of Cash Flow Valuation.Tham. 1997. una aproximación al análisis de alternativas. Vélez-Pareja. Ignacio. Ignacio. Vélez-Pareja.com/abstract=196588. 1998.. Ignacio. Superintendencia del Subsidio Familiar.

If preferred stock exist. the working capital is the difference between current assets (inventory. cash and accounts receivable) and current liabilities (accounts payables. Estimating Cash Flows: FCFE • Cash flows to Equity for a Levered Firm Net Income . using a model that focuses only on dividends will under state the true value of the equity in a firm. however.new debt issues) o The common categorization of capital expenditures into discretionary and non-discretionary loses its basis when there is future growth built into the valuation.APPENDIX Explanation of Professor Damodaran regarding the items to be included in the CFE Aswath Damodaran 95 Slides 94 to 97 Dividends and Cash Flows to Equity • In the strictest sense. short term debt and debt due within the next year) A cleaner definition of working capital from a cash flow perspective is the difference between non-cash current assets inventory and accounts receivable) and non-debt current liabilities (accounts payable).(Principal Repayments . the only cash flow that an investor will receive from an equity investment in a publicly traded firm is the dividend that will be paid on the stock. since there are both non-cash revenues and expenses in the earnings calculation o Even if earnings were cash flows. This cannot be true for several reasons: o Earnings are not cash flows.(Capital Expenditures .New Debt Issues) = Free Cash flow to Equity • I have ignored preferred dividends.” Observe that investment of excess cash is not included in the definition of working capital. where earnings are discounted back to the present. are set by the managers of the firm and may be much lower than the potential dividends (that could have been paid out) o managers are conservative and try to smooth out dividends o managers like to hold on to cash to meet unforeseen future contingencies and investment opportunities • When actual dividends are less than potential dividends.Changes in non-cash Working Capital10 . a firm that paid its earnings out as dividends would not be investing in new assets and thus could not grow o Valuation models. preferred dividends will also need to be netted out 10 From slide 92 (Damodaran 95): “In accounting terms. will over estimate the value of the equity in the firm • The potential dividends of a firm are the cash flows left over after the firm has made any “investments” it needs to make to create future growth and net debt repayments (debt repayments .Depreciation) . • Actual dividends. 21 . Measuring Potential Dividends • Some analysts assume that the earnings of a firm represent its potential dividends.