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Dividends investing activity

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There are no potential dividends in their articles. The same is true even in Miller and Modigliani where the irrelevance of dividends is proved. Miller and Modigliani do not deal with potential dividends retained in the firms and invested in liquid assets. There are no investments in liquid assets in Miller and Modigliani See also Magni, Therefore, it is true that the unpaid dividends will be distributed at the terminal date, so that their value is captured in the terminal or continuing value.

But it is never sufficiently stressed that irrelevance holds if and only if, a perfect market exists where cash excess not paid is invested at the opportunity cost of equity. In real life, excess cash is invested in liquid assets at some available rate that might be greater, equal or lower than the cost of equity. This means that the NPV of those undistributed funds can be greater, equal or less than zero.

Consistency between cash flows and financial statements. There should be a complete consistency between cash flows and financial statements. If one says that every dollar available belongs to the equity holders, then that fact should be reflected in the financial statement. That is, those funds should appear as effectively distributed.

In a valuation where a finite planning horizon is considered, decisions on what to do with excess cash are reflected in the financial model. This implies that if management foresees to invest in marketable securities, that decision should appear in the financial statements. On the other hand, if cash holdings are invested in additional operating assets, that decision should be included in the analysis; if they are devoted to acquisitions or buyouts, again, that decision should be reflected in the cash flows with all the financial implications it has.

After this finite planning horizon, one makes the assumption that all available cash is distributed to equity and debt holders; the finite planning horizon should cover the largest possible period and at the end, a continuing or terminal value should measure the value generated for perpetuity. Tax distortion. When one includes in the CFE the excess cash invested in liquid assets, one does distort taxes.

Instead of recording an explicit return usually a low return that is taxed and listed in the income statement, one creates a virtual return equivalent to the cost of equity, k e , which is not taxed in reality. Here, by virtual return we mean the return obtained implicitly when we distribute the cash flow to the owners the debt and equity holders. When we assume that funds that are invested at a rate usually lower than the discount rate are part of the cash flow, we are assuming implicitly that those flows are reinvested at the same discount rate, but those returns are not listed in the income statement and not taxed, and go directly to the pocket of the owners.

Here, it is important to take into account of this: cash flows for valuation are what goes out from the firm and is paid to the capital owners debt and equity holders. When that cash flow is received by them, it is assumed that they invest those funds at their respective rates of return cost of equity, k e. The problem arises when the firm does not pay out the cash flow and invests it in liquid assets.

The value of the firm is not in the funds that remain inside the firm, but in the funds that go out. Firm value increases if and only if cash is actually pulled out from the firm and distributed to the owners of debt or equity. Therefore, to consider potential dividends as actually pulled out by the firm is like trying to pull potential rabbits out of actual hats. Zero-NPV assumption in real-life applications. One argument often used to justify the inclusion of cash holdings as a cash flow is that: the net present value of those investments is zero.

We might agree on this assump tion as a conservative approach to avoid excessive optimism as well as the determination in a forecast of a very high return on those invested funds. However, in constructing pro forma financial statements forecasting one should look the history of the firm and estimate the historical returns on those funds, and forecast them accordingly to the historical average return. If the forecasted return is lower than the discount rate of the cash flows, the effect is that there is a destruction of value.

If higher, a creation of value occurs. The idea of assuming without question that the NPV of the investment in market securities is zero implies that whatever the analyst or the management will do with those funds are of no concern to investors, because their funds do not contribute to value creation they are value-neutral.

Then, a simple conclusion could be drawn if one accepted the idea that the investment of cash excess does not affect the firm value: whether one keeps it in the safe box, in the bank, invested in an investment fund or whatever else, it will make no difference because the NPV is zero. This should lead many people and institutions to refrain from offering solutions for cash management purposes, such as the following.

No financial discipline is more important and yet more overlooked and misunderstood than the essential principles and practices of corporate cash and liquidity management. The lesson is simple: Those companies that handle cash best thrive most Cash Management Fundamentals, A shareholder would not accept to be virtually paid with potential dividends that never go to her pocket; similarly, banks or, in general, debt holders would not accept that interest or principal payments should be paid with potential interest and principal payments.

Will practitioners and teachers accept an invitation to tell their customers and students to disregard the importance of cash management? Will they spread the idea that keeping the excess cash in the bank account with no interest would mean the same in terms of value than investing it wisely?

Obviously not. Certainly, there should be ways to avoid that managers waste the excess cash in bad investments. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. Therefore, although corporate financial theory may conveniently employ the assumption of full distribution of cash generated, in practice this does not happen, as Jensen underlines, so there is a need for distinguishing between potential cash flow available for distribution and actual cash flow effectively paid out to equity and debt holders.

The fact that in theory firms should distribute the available cash does not imply that the analyst should assume that in the future all available cash will be distributed, if historically the firm has not distributed it. In this section we formalize three arguments that logically support the thesis according to which undistributed potential dividends do not add value to shareholders and therefore must not be included in the definition of Cash Flow to Equity.

In particular, they show that the use of potential dividends for valuation: a does not comply with the CAPM, b does not comply with the basic tenet of valuation theory, c does not comply with the no-arbitrage principle. The use of undistributed potential dividends is in clear contradiction with the Capital Asset Pricing Model. When the CAPM is used to estimate the cost of equity, ke, one uses dividends paid out to calculate the historical stock returns and historical beta; one never uses potential dividends.

Suppose i an investor uses the CAPM for computing the cost of equity and ii uses undistributed potential dividends for valuation. Due to i , the following relation holds:. This implies:. However, due to ii ,. The basic tenet of valuation theory. Miller and Modigliani, in turn, strictly abide by a basic tenet of valuation theory: value depends on cash flow received by the investor.

This principle may be formalized as:. By making us of i undistributed potential dividends for valuation and ii the basic tenet of valuation theory, one incurs contradictions. If undistributed potential dividends enters valuation, then.

Therefore, eq. Arbitrage: a counterexample. The no-arbitrage principle is a cornerstone in financial theory Varian, and decision theory Smith and Nau, , and, more generally, represents a norm of rationality in economics Nau and McCardle, We now illustrate a counterexample showing that if an investor uses undistributed potential dividends for valuation, then she is open to arbitrage losses.

Consider a firm whose shares are traded in the market, and assume, for the sake of simplicity, that one shareholder owns all the shares. Suppose potential dividends will be, a perpetual if state of nature 1 occurs, and a perpetual 70 if state of nature 2 occurs, but dividends will be, in each year, a perpetual in state of nature 1 and a perpetual 50 in state of nature 2 equal probability is assumed.

This means that undistributed potential dividends amount to a constant 20 with certainty. The probability for each state of nature is 0,5. This means that the investor will own a firm which she values at Then, the ownership proposes a contract according to which the investor receives and while paying the ownership a constant if state of nature is 1 and a constant 50 if state of nature is 2.

To the investor, such a cash flow stream is equivalent to the cash flow stream distributed by a firm which is equal to the firm just purchased but with no undistributed potential dividends. Therefore, to her the value of such a stream is equal to value of the firm just purchased less the value of the undistributed potential dividends.

The undistributed potential dividends are a certain amount because she will receive them in either state of nature. Hence, the discount rate should be the risk free rate. The investor is then required to give up a value of in order to get an immediate amount equal to This strategy results in an arbitrage loss for the investor and an arbitrage profit for the arbitrageur Table 1. Hence, if one does not accept the basic tenet of valuation theory, one is open to arbitrage losses to avoid arbitrage, one needs to value undistributed potential dividends at zero.

There is empirical evidence that dividends and not liquid assets are what increases firm value. Pinkowitz et al. Using our symbols, the model tested by Pinkowitz et al is described as:. The results by Pinkowitz et al. They allow us to estimate the implicit discount rate that makes an extra dollar in each of those components equal to the amount announced by the authors.

The discount rate the market applies to one dollar in cash is extremely high, while the discount rate for the dividends is reasonable. If one assumes that those coefficients are related to one period and not to a perpetuity, one obtains the results shown in Table 3b. In these cases we can see that the implicit discount rate for one period has huge differences between cash and dividends.

We can say in general that the market punishes cash compared with dividends as seen by the discount rate, which is much greater than the discount rate for dividends. The discount rates shown are very high and unusual and might be interpreted as something undesirable to the market. In any case, one can only infer that dividends create much more value than cash, not that cash is positively evaluated results for a single period are shown in Table 4b.

As the saying goes: whether a glass is half full or half empty depends on the attitude of the person looking at it. Those who see the glass half full might say: this is a proof that cash creates value and hence should be included in the cash flows. Others and we are in this number see the glass half empty and say: the market is adverse to potential dividends because it discounts them with a huge rate, so trying to keep their value down to zero.

Hence, they should not be included as cash flow because this is counter to evidence and overstates the value of the firm. The findings presented in Pinkowitz and Williamson and Pinkowitz et al. Using the aggregate data from Pinkowitz et al. This is an average, and it compares with the above mentioned findings. The data from Pinkowitz et al. Data cover ten years for 35 countries with some exceptions such as India, Philippines, Turkey and Peru.

This means that they had near The values in Table 6 are the mean of the medians for each variable for each country. Dividends and liquid assets are the percent of those items in the balance sheet on Total assets. The liquid assets are not calculated individually but they are added Pinkowitz et al. Using the aggregated data shown in Pinkowitz et al. The aggregated data we have used are shown in Table 6. Notice that the three variables are scaled or normalized by book value of total assets.

This means that one may compare firms of different size and from different countries and years. We are aware that the model lacks good specification because there are other variables that have to be included, it is based on aggregated data and it does not represent the true universe studied by Pinkowitz et al. This exploration only gives hints and trends. After the regressions have been run, significant models are only those with the independent variable Dividends in linear form.

This means linear Lin Lin and semi logarithmic Log Lin models. In particular, the only significant variable is Dividends. In Table 7 we summarize the statistical analysis. And as is suggested by Table 7 , the results in terms of statistical significance corroborate the linearity between value and CFE.

In particular, one dollar in dividends creates about 8 dollars in value see Graph 1. We are aware that this analysis is rather restricted because we are dealing with aggregated data and not with the raw data Pinkowitz et al. Another restriction is related to the interpretation of the results. Admittedly, we do not have full information regarding the specific model used in each case of the report.

This is actually critical if we are interested in defining the coefficient of the independent variable as the increase in value for each extra dollar in the variable. The previous sections have shown that change in liquid assets must not be included in the notion of CFE.

However, future research should bring corroboration to the idea that the market do not positively value change in liquid assets. Armed with the theoretical toolbox we have developed in section 1, this last section proposes a model for tests, which, we expect, will add empirical evidence. The model is based on standard results of corporate financial theory and, in particular, on Modigliani and Miller We use the following equation:.

The cash flow paid to the investors is related to CFE as follows:. From eqs. Using eqs. If markets positively valued changes in liquid assets, then the levered value of the firm, as empirically evidenced by the market, would not be the theoretically correct eq. We expect to find that in eq. For the implementation of the test, we will need to collect information which is usually publicly available:.

In order to normalize the data and avoid problems of size, currency, time, etc. These independent variables are the proxies for components of equation While Pinkowitz et al. Hence, our econometric model will be for each firm. Where all variables are now meant to be divided by book value of assets. With this model, the value of the firm depends on the cash flows the owners of equity and debt expect to receive in the future and on potential dividends as well.

With this model we attempt to measure how much value is created for a given value and cash flows in the following period. An alternate model is. Where a proprietary approach is followed, and where E t is measured as number of shares times market price per share we will use data from Latin American countries.

Given that eq. While the two models in eqs. To this end, the various betas are to be interpreted as the discount factors for the independent variables. If our hypothesis will be corroborated as already implied by both modern finance theory and the reported empirical findings , the practice of assuming that liquid assets are part of the cash flows will be not only theoretically but also empirically refuted.

Economics, and in particular, financial economics provide rigorous theoretical tools for valuing assets. The theory is clear in stating that the value of an asset depends on the cash flow actually received by investors, not on the cash flows that could be received, unless undistributed potential dividends are invested in zero-NPV activities and their full present value is distributed to shareholders DeAngelo and DeAngelo, , Magni, But if, historically, the firm has not distributed all the available cash, there is no reason to assume that in the future it will be different.

Benninga and Sarig, ; Copeland et al. Cash Flow to Equity should be defined as dividends paid minus net capital contributions, i. The issue is tackled in the document in three ways: economic, logical, and empirical. Economically, several reasons are given which confirm that only actual cash flows are relevant in valuation; logically, three formal proofs are provided that make use of the CAPM, of the basic tenet in valuation theory, and of arbitrage theory; empirically, recent findings in the literature are analyzed among which Pinkowitz et al.

An interpretation of these findings is that the market does not consider potential dividends a value driver. The main conclusion from this work is that practitioners and teachers should abandon the practice to not include liquid assets in the working capital when calculating cash flows. The authors we analyze Damodaran, Copeland, etc. It is worth noting that the definition of potential dividend is ambiguous in corporate finance textbook, because ordinary language and numerical examples are used instead of rigorous formalism, and there is no standard terminology across writers, so increasing problems of understanding.

Intuitively, people think of cash flows as net cash after adding inflows and subtracting all inflows. But inflows for capital providers are outflows for the firm. See Table 3a and 3b in section 4 and the difference between discount rates. Benninga, S. Corporate Finance. A Valuation Approach. Brealey, R. Principles of Corporate Finance 7th ed. Northwestern University Website. Copeland, T. Valuation: Measuring and Managing the Value of Companies. Valuation: Measuring and Managing the Value of Companies 2nd ed.

The legal union of two or more corporations into a single entity, typically assets and liabilities being assumed by the buying party. One of the components of the cash flow statement is the cash flow from investing. An investing activity is anything that has to do with changes in non-current assets -- including property and equipment, and investment of cash into shares of stock, foreign currency, or government bonds -- and return on investment -- including dividends from investment in other entities and gains from sale of non-current assets.

These activities are represented in the investing income part of the income statement. It is important to note that investing activity does not concern cash from outside investors , such as bondholders or shareholders. For example, a company may decide to pay out a dividend. A dividend is often thought of as a payment to those who invested in the company by buying its stock.

However, this cash flow is not representative of an investing activity on the part of the company. The investing activity was undertaken by the shareholder. Therefore, paying out a dividend is a financing activity. It is important to remember that, as with all cash flows, an investing activity only appears on the cash flow statement if there is an immediate exchange of cash. Therefore, extending credit to a customer accounts receivable is an investing activity, but it only appears on the cash flow statement when the customer pays off their debt.

Boundless Finance. Financial Statements, Taxes, and Cash Flow.

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