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

CASH FLOW TO EQUITY)

Ignacio Vlez-Pareja Master Consultores Cartagena, Colombia nachovelez@gmail.com

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 Gutirrez (juancg@proteccion.com.co) y Eduardo Petracca (epetracca@arnet.com.ar). Any mistake is my entire responsibility.

First version: January 3, 2004 This version: August 5, 2013

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. This work analyzes the definition of cash flows for valuation (free cash flow and cash flow to equity). We examine the empirical evidence in the recent literature and we present 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. We analyze the evidence reported in the literature that liquid assets items in the balance sheet (potential dividends) do not contribute to value creation and hence should not be included in the cash flows. This fact reinforces previous arguments on the inconvenience of adding the change in liquid assets as part of the cash flows for firm valuation. Tham and Vlez-Pareja (2004), VlezPareja (1994, 1997, 1998, 1999, 2004a, 2004b y 2006)have asserted that liquid assets items found in the Balance Sheet (BS) should not be considered as cash flows for firm valuation. On the other hand, some respected authors (Copeland, et al, 1995, 2000, Benninga et al. 1997, and Damodaran, 2004, Jensen, 1986, Brealey et al, 2003, Copeland and Weston, 1988, among many others) support the idea that the CFE has to include potential dividends. This definition openly contradict the essential and basic concepts of cash flow and time value of money. Pinkowitz, Williamson and Stulz, (2007) and Pinkowitz and Williamson (2002) present findings related to firms in developed and emerging countries where there is some minor relationship of cash holdings with the MV/BV ratio. In this work 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
1

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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)

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. 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

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reflected in the financial statements behind the practice of including as cash flow items that appear in the Balance Sheet. We analyze the evidence found in the recent literature and it shows that liquid assets in the Balance Sheet (BS), called by some "potential dividends", do not contribute to the creation of value and therefore should not be included in the cash flows. This reinforces arguments discussed by some authors about the inconvenience of adding the change in liquid assets to cash flows for firm valuation. Tham and Vlez-Pareja (2004), Vlez-Pareja (1994, 1998, 1999, 2004) have claimed that the liquid assets that are in the BG should not be regarded as cash flows and that the most straightforward approach to derive the cash flows is starting from the cash budget3. On the other hand, some highly respected authors (Copeland, et al, 1995, 2000, Benninga et al. 1997 and Damodaran, 2004, Jensen, 1986, Brealey et al, 2003, Copeland and Weston, 1988, among others) argue the idea that the equity cash flow should be included as "potential dividends". This definition contradicts the basics and essentials of what a cash flow and the concept of the value of money over time. Pinkowitz, Williamson and Stulz (2007) and Pinkowitz and Williamson (2002) present empirical evidence on developed and emerging countries where there is a relatively minor relationship between holdings of liquid assets and the ratio MV/BV or Tobin's Q. The literature shows that holding liquid assets destroys value or at most do not create a significant amount of value. Schwetzler and Reimund (2003) report that in Germany persistent excessive cash holdings lead to a significant operating

underperformance [] in line with expectations of the agency theory (p. 25).4 Harford

The cash budget is a financial statement where every inflow and outflow is listed and the difference is the period net cash flow. The accumulated balance resulting form the net cash flow has to match with the cash on hand found in the Balance Sheet.
4

Italics ours from now on, unless otherwise specified.

(1999)5 finds that cash-rich bidder destroys seven cents of firm value for every dollar of excess cash held (p. 1983) and says that the stock market appears to partially anticipate this behavior, as evidenced by the negative stock market reaction to cash stockpiling. (p. 1972). Finally, he says that one might expect that stockpiling cash would be greeted negatively by the market (p. 1992). Opler, Pinkowitz, Stulz and Williamson (1999) say that holdings of liquid assets can make shareholders worse off in some circumstances (p. 2). Finally, they write that investing in cash can therefore have an adverse effect on firm value. To put it another way, increasing firms holdings of liquid assets by one dollar may increase firm value by less than one dollar (p. 11). Faulkender and Wang (2004) find that the marginal value of cash declines with larger cash holdings (p. 2). On the other hand, Mikkelson (2003) concludes that persistent large holdings of cash and equivalents have not hindered corporate performance, (p. 2) and that there is no evidence that large firms with lower insider stock ownership, higher inside board composition, or a controlling founder perform differently than other large cash firms (p. 20). This said, it is counter evident that what destroys value (keeping cash) by some manipulation, ends up creating value as when cash flows are inflated assuming full distribution when the firm keeps cash and quasi cash in its Balance Sheet. It is important to say that the context of this paper is for nontraded firms. When the firms are traded, and the assumptions of a perfect market are met, it could be shown, using arbitrage arguments, that the value is the same if the firm distributes or not the cash excess.

Quotations from this author are taken from the SSRN version, 1997.

SOME CONSIDERATIONS REGARDING THE TYPICAL PRACTICE Some respected authors (Copeland, et al, Benninga et al.6 and Damodaran) support the idea that the CFE has to include potential dividends. 7 On the other hand, professor Damodaran has, in some slides found at his website, excellent arguments to favor the idea that the CFE has to include just what the stockholders actually receive, however, 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).8 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. Hence, the strict definition of CFE is dividends plus repurchase of stock and minus equity investment. Some other arguments to reinforce this idea are: 1. 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 discount cash flows when they are received. 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. 2. The use of potential dividends is in clear contradiction with the Capital Asset Pricing Model, CAPM. When the CAPM is used to estimate the cost of equity, Ke, we use dividends paid; we never use potential dividends. We never add to the dividends use to calculate the return of a stock the items in

Benninga says: [] Free Cash Flow (FCF) a concept that defines the amount of cash that the firm can distribute to security holders. [] 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. 7 Professor Tom Copeland in a private correspondence says: If funds are kept within the firm you still own them - hence "potential dividends" are cash flow available to shareholders, whether or not they are paid out now or in the future. 8 See the transcription of the relevant slides in the Appendix

the balance sheet listed as cash in hand and marketable securities. More. If to estimate the cost of capital we depart from the betas found in the market, they capture the risk of the stock using paid dividends and the value the market assign to the stock discounting the future dividends. It is argued that when cash excess is invested in 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. This is not reasonable because precisely the beta coefficient captures the risk of paid dividends, and the dividends are a function of the net income, 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. 3. The same idea of Miller y Modigliani, M&M, 1961, about the irrelevance of dividends should deter that practice. Even if dividends are not paid the value is captured in the terminal value, TV. Then it is not clear at all why we should insist on using as CF what it is not. 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. 4. Our position is that there should be a complete consistency between cash flows and financial statements. If we say that every penny available belongs to the cash flow to the equity holder (CFE), then that fact should be reflected at the financial statement. 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, for instance. 5. When including the excess cash invested in marketable securities and cash as part of the CFE we are distorting the taxes. In fact we are. Instead of generating an explicit return (usually very low) that is taxed in the income statement, we generate a virtual return at the cost of equity, Ke, that is not taxed in reality. 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). This virtual or implicit return is one of the implicit assumptions when we discount cash flows. This is an old proposal from Lorie and Savage (see Lorie and Savage (1955)). When we assume that some funds are invested at a rate that usually is lower than the discount rate, and yet we incluye those funds in the cash flow, we are assuming implicitly that those cash flows are reinvested at the same discount rate we use to discount them, but those implicit returns never are taxed. Here it is important to say take into account the following: cash flows are what the firm pays to the owners of capital, be it debt or equity. 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). 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. If those funds are in the cash flows, it is as if the equity holders

have received them, but they have not, and when we discount the flows at the discount rate be it the cost of levered equity, Ke, or the weighted average cost of capital (WACC), 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 funds are investid in market securities). It might sound as a paradox but, the firm is worth because the capital owners withdraw funds from the firms. 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. The outflows (the CFD and the CFE adjusted by tax savings) from the firm are the free cash flow! 6. 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. 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 same time we include the invested funds in the CFE we are concealing a financial malpractice. In other words, it would mean that it would be the same to have the excess cash invested at high or low rates. There is some empirical evidence that dividends and not cash in hand or invested in market securities is what increases firm value. Data from Pinkowitz, Williamson and Stulz, (2007) present evidence of this fact. Data cover ten years with some exceptions such as India, Philippines, Turkey and Peru. 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. Dividends and

Cash and market securities is the percent of those items in the Balance Sheet on total assets. We have run a simple linear regression between MV/BV, Cash and market securities and dividends. See table and statistical analysis below. The values in the table are the mean of the medians for each variable for each country. Table 1a. Dividends, Cash & market securities and MV/BV by country
Country Argentina Australia Austria Belgium Brazil Canada Chile Denmark Finland France Germany Greece Hong Kong India Ireland Italy Japan Korea (South) Malaysia Mexico Netherlands New Zealand Norway Peru Philippines Portugal Singapore South Africa Spain Sweden Switzerland Thailand Turkey UK USA Dividends 0.013 0.023 0.009 0.013 0.006 0.007 0.045 0.009 0.009 0.008 0.011 0.026 0.029 0.014 0.014 0.01 0.005 0.004 0.014 0.007 0.014 0.024 0.006 0.011 0.003 0.009 0.013 0.025 0.014 0.013 0.011 0.021 0.042 0.024 0.008 Cash 0.065 0.044 0.066 0.089 0.047 0.026 0.046 0.138 0.08 0.085 0.056 0.037 0.102 0.025 0.094 0.089 0.16 0.064 0.055 0.057 0.048 0.015 0.119 0.048 0.076 0.025 0.138 0.056 0.039 0.092 0.108 0.026 0.094 0.062 0.044 MV/BV 0.769 1.013 0.758 0.809 0.586 0.967 1.125 0.889 0.817 0.711 0.822 1.164 0.834 1.301 0.947 0.655 1.014 0.783 1.344 0.972 0.813 0.969 0.897 1.046 1.29 0.763 1.013 0.893 0.808 0.861 0.821 1.174 1.389 0.997 1.151

Source: Pinkowitz, Williamson and Stulz, (2007) 10

The regression with MV/BV as dependent variable and the other two variables as independent variables, Cash and market securities leaves the model for statistic significance. When the regression is run with only dividends and MV/BV the result is Table 1b. Coefficient and significance of MV/BV dependent variable Coefficients Probability Intercept 0,83040682 4,7122E-16 Dividends 7,97813497 0,01806838 Critical value for F is 0.01806838 In other words, cash in hand or invested in market securities do not increase the firm value. What increase that value are dividends paid to equity holders. 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. Tham and Vlez-Pareja (2004) propose explicitly to include in the CFE only the cash that is received or distributed to the equity holder. The approach departs from the cash budget, CB statement. In this financial statement they present four modules or sections. Two of these sections include the transactions with debt and equity holders. From there the CFE and the cash flow to debt, CFD can be derived straightforward. The financial statements and the cash flows are completely integrated. This allows the analyst to see what is going on. As can be seen below in a simple example, when total excess cash is distributed then initial equity could be reduced and eventually reach negative values. Would a financial analyst dare to present a financial model where equity becomes negative? We are sure she will not. AN EXAMPLE9 This is an example where the book value leverage D% affects the growth of the firm and the accounts payable conditions. The higher the D% the lower the growth and the
9

This example is available directly from the author, but titles are in Spanish.

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stringent accounts payable conditions (when D% is higher than a given value, (for instance, 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). Next we show the Balance Sheet and the Cash Budget. We indicate the derivation of the CFE and the cost of equity, Ke, as well.
Table 2a. Cash Budget, CB when payout ratio is 100% and any excess cash in invested in market securities.
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 0.0 121.7 1,161.0 2,298.6 3,683.5 2,242.6 -46,680.0 15,461.6 16,080.6 16,906.8 -38,026.1 22,253.5 16,632.7 0.0 16,632.7 3,326.5 0.0 0.0 3,457.0 3,654.2 5,023.9 3,326.5 0.0 0.0 3,547.8 3,003.2 6,203.1 3,326.5 0.0 0.0 3,684.0 2,154.9 7,741.4 3,326.5 0.0 0.0 3,784.9 1,465.8 -16,642.2 3,326.5 5,992.2 0.0 3,881.5 4,158.0 6,850.7 0.0 0.0 29,961.0 0.0 1,955.4

0.0 -13,414.6

15,000.0 0.0 0.0 1,585.4 0.0 0.0 5,023.9 226.0 0.0 5,977.1 2,156.2 0.0 5,585.2 4,268.8 0.0 -20,911.0 19,534.1 1,386.9 0.0 10.0 130.0 6,840.7 0.0 10.0 0.0 0.0 0.0 10.0 140.0

0.0 6,509.3 12,971.7 0.0 495.4 987.1 6,509.3 12,971.7 19,534.1 10.0 110.0 10.0 120.0

1,585.4 -1,485.4 1,585.4 100.0

We have listed the taxes paid in order to compare how taxes change when one or another method is used. Now we show the Balance Sheet

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Table 2b. Balance Sheet, BS when payout ratio is 100% and any excess cash is invested in market securities.
Year 0 Year 1 100.0 2,440.8 1,937.9 6,509.3 10,988.0 33,750.0 44,738.0 2,377.9 0.0 2,377.9 13,306.1 13,828.0 29,511.9 15,000.0 226.0 44,738.0 60.65% 0.0 Year 2 110.0 2,617.6 2,094.1 12,971.7 17,793.5 22,500.0 40,293.5 2,514.3 0.0 2,514.3 9,979.6 10,643.4 23,137.3 15,000.0 2,156.2 40,293.5 51.18% 0.0 Year 3 120.0 2,835.0 2,228.6 19,534.1 24,717.7 11,250.0 35,967.7 2,678.0 0.0 2,678.0 6,653.1 7,367.9 16,699.0 15,000.0 4,268.8 35,967.7 38.98% 0.0 Year 4 130.0 3,055.9 2,311.1 0.0 5,497.0 56,193.2 61,690.2 2,777.0 0.0 2,777.0 33,287.6 3,784.9 39,849.5 15,000.0 6,840.7 61,690.2 60.09% 0.0 Year 5 140.0 3,294.5 2,425.9 0.0 5,860.3 42,144.9 48,005.2 2,916.2 1,955.4 4,871.5 23,968.8 0.0 28,840.3 15,000.0 4,164.9 48,005.2 54.00% 0.0

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) 1,585.4 0.0 1,680.0 0.0 3,265.4 45,000.0 48,265.4 0.0 0.0 0.0 16,632.7 16,632.7 33,265.4 15,000.0 0.0 48,265.4 68.92% 0.0

Check

From Module 3 at the CB we construct the CFE: Table 3. 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 0.0 0.0 0.0 0.0 Payment of dividends 0.0 226.0 2,156.2 4,268.8 6,840.7 Repurchase of shares 0.0 0.0 0.0 0.0 0.0 CFE 0.0 226.0 2,156.2 4,268.8 6,840.7 TV debt 32,112.0 CFE with TV for CFE 0.0 226.0 2,156.2 4,268.8 38,952.7 Ke 19.90% 17.99% 16.96% 15.70% 16.83% Levered equity 21,109.0 25,310.0 29,636.9 32,506.8 33,342.5

Observe that the CFE is derived directly from Module 3 in the CB (except the terminal value at year 5 and Ke, calculations not shown).

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The values for equity and firm (calculation not shown) are: equity value is 21,109.0 and firm value is 54,374.4 that is equal to equity value plus debt. Table 4. Cash Budget, CB when layout ratio is 100% and any excess cash is paid to the
equity holder.
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 0.0 121.7 987.7 1,953.1 3,198.0 1,446.3 -46,680.0 14,556.7 15,051.9 17,042.6 -38,880.0 20,839.5 16,632.7 0.0 16,632.7 3,326.5 0.0 0.0 3,457.0 3,654.2 5,023.9 3,326.5 0.0 0.0 3,547.8 3,003.2 6,376.5 3,326.5 0.0 0.0 3,684.0 2,154.9 8,086.9 3,326.5 0.0 0.0 3,784.9 1,465.8 3,627.1 3,326.5 9,949.0 0.0 3,881.5 6,433.1 5,939.2 0.0 0.0 49,745.0 0.0 6,479.5

0.0 -13,414.6

15,000.0 0.0 6,609.3 1,585.4 0.0 0.0 1,585.4 1,585.4 -1,585.4 0.0 0.0 0.0 -1,585.4 0.0 226.0 6,150.5 0.0 0.0 0.0 0.0 0.0 0.0 1,834.2 6,252.7 0.0 0.0 0.0 0.0 0.0 0.0 3,627.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 5,939.2 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Observe the taxes paid in this case and in the previous one. For instante, taxes for years 3, 4 and 5 are 2,298.6, 3,683.5 y 2,242.6 in the first case; in the second case they are 1,953.1, 3,198.0 y 1,446.3 respectively. This indicates a very important variation in taxes. Next we show the Balance Sheet

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Table 5. Balance Sheet, BS when payout ratio is 100% and any excess cash is paid to the equity holder
Year 0 Year 1 0.0 2,440.8 1,937.9 0.0 Year 2 0.0 2,617.6 2,094.1 0.0 Year 3 0.0 2,835.0 2,228.6 0.0 Year 4 0.0 3,055.9 2,311.1 0.0 Year 5 0.0 3,294.5 2,425.9 0.0

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) 1,585.4 0.0 1,680.0 0.0

3,265.4 4,378.7 4,711.8 5,063.7 5,367.0 5,720.3 45,000.0 33,750.0 22,500.0 11,250.0 56,193.2 42,144.9 48,265.4 38,128.7 27,211.8 16,313.7 61,560.2 47,865.2 0.0 0.0 0.0 2,377.9 0.0 2,377.9 2,514.3 0.0 2,514.3 9,979.6 2,678.0 0.0 2,678.0 7,367.9 2,777.0 0.0 2,777.0 3,784.9 2,916.2 6,479.5 9,395.7 0.0

16,632.7 13,306.1

6,653.1 53,071.5 39,796.0

16,632.7 13,828.0 10,643.4 15,000.0 0.0 8,390.7 226.0

33,265.4 29,511.9 23,137.3 16,699.0 59,633.4 49,191.6 2,240.2 -4,012.4 1,834.2 3,627.1 -4,012.4 -4,012.4 5,939.2 2,686.0

48,265.4 38,128.7 27,211.8 16,313.7 61,560.2 47,865.2 68.92% 71.16% 75.79% 85.95% 92.36% 96.68% 0.0 0.0 0.0 0.0 0.0 0.0

Check

Observe the net equity in the Balance Sheet. When cash flows are calculated using the traditional approach, 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, we construct the next table to derive the CFE: Table 6. 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 0.0 0.0 0.0 0.0 0.0 Payment of dividends 0.0 226.0 1,834.2 3,627.1 5,939.2 Repurchase of shares 6,609.3 6,150.5 6,252.7 0.0 0.0 CFE 6,609.3 6,376.5 8,086.9 3,627.1 5,939.2 TV debt 11,620.8 CFE with TV for CFE 6,609.3 6,376.5 8,086.9 3,627.1 17,560.0 Ke 15.65% 15.10% 15.10% 14.56% 14.01% Levered equity 24,010.8 22,056.5 19,741.7 15,186.6 14,143.0

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Again, observe that the CFE is derived directly from Module 3 in the CB (except the terminal value at year 5 and Ke, calculations not shown). Values for equity and firm (the calculation is not shown) are: equity value is 24,010.8 and firm value, 57,276.1 and it is equal to equity value plus debt. Observe the BS and look at the equity and retained earnings together. Equity has been reduced steadily from year 1 to year 5. The sum of the 2 items is positive in some years, but we have to pay the retained earnings just the next year. Then we can say that equity is in fact negative for the last 3 years. The relevant issue here is that when the FCF or the CFE is derived from the Income Statement and the Balance Sheet, 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. 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. Now we will examine what occurs when the common practice is used, that is, calculating the cash flows from the Income Statement and not including the cash in hand and the market securities in the working capital. 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, this is, that cash is held in the bank and there is investment in market securities. 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.

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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 0.0 1,680.0 1,680.0 0.0 0.0 0.0 0.0 1,680.0 Year 1 2,440.8 1,937.9 4,378.7 2,377.9 0.0 0.0 2,377.9 2,000.8 320.8 Year 2 2,617.6 2,094.1 4,711.8 2,514.3 0.0 0.0 2,514.3 2,197.4 196.6 Year 3 2,835.0 2,228.6 5,063.7 2,678.0 0.0 0.0 2,678.0 2,385.7 188.3 Year 4 3,055.9 2,311.1 5,367.0 2,777.0 0.0 0.0 2,777.0 2,590.0 204.3 Year 5 3,294.5 2,425.9 5,720.3 2,916.2 1,955.4 0.0 4,871.5 848.8 -1,741.2

Now we calculate the FCF and the CFE departing from the Income Statement. Table 8: Calculation of cash flows and value (cash excess 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 CFD10 Ke Equity value Year 1 Year 2 Year 3 Year 4 Year 5 0,0 4.654,2 6.188,3 8.143,6 10.804,8 10.662,1 0,0 -1.629,0 -2.165,9 -2.850,3 -3.781,7 -3.731,7 0,0 11.250,0 11.250,0 11.250,0 11.250,0 14.048,3 0,0 -320,8 -196,6 -188,3 -204,3 1.741,2 -45.000,0 0,0 0,0 0,0 -56.193,2 0,0 -45.000,0 13.954,4 15.075,8 16.355,1 -38.124,3 22.719,8 1.507,3 1.178,2 897,2 583,7 1.489,1 15.461,6 16.254,0 17.252,3 -37.540,6 24.208,9 58.036,2 15.461,6 16.254,0 17.252,3 -37.540,6 82.245,1 56.554,5 49.941,4 41.228,8 30.202,3 72.138,9 23.289,1 5.023,9 6.376,5 8.086,9 -16.156,8 40.918,1 19,5% 18,3% 17,8% 16,9% 16,7% 23.289,1 22.807,3 20.605,8 16.181,3 35.066,4

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, no investment in market securities.

10

CFD is derived from module 2 in the CB.

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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, now they are at zero, except for year 0). 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
0.0 1,680.0 1,680.0 0.0 0.0 0.0 0.0 1,680.0

Year 1
2,440.8 1,937.9 4,378.7 2,377.9 0.0 0.0 2,377.9 2,000.8 320.8

Year 2
2,617.6 2,094.1 4,711.8 2,514.3 0.0 0.0 2,514.3 2,197.4 196.6

Year 3
2,835.0 2,228.6 5,063.7 2,678.0 0.0 0.0 2,678.0 2,385.7 188.3

Year 4
3,055.9 2,311.1 5,367.0 2,777.0 0.0 0.0 2,777.0 2,590.0 204.3

Year 5
3,294.5 2,425.9 5,720.3 2,916.2 6,479.5 0.0 9,395.7 -3,675.3 -6,265.3

As before, now we calculate the FCF and the CFE departing from the Income Statement.

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 CFD11 Ke Equity value
0.0 0.0 0.0 0.0 -45,000.0 -45,000.0

Year 1
4,654.2 -1,629.0 11,250.0 -320.8 0.0 13,954.4 1,507.3 15,461.6 15,461.6 52,935.4 5,023.9 19.1% 25,801.3

Year 2
6,188.3 -2,165.9 11,250.0 -196.6 0.0 15,075.8 1,178.2 16,254.0 16,254.0 44,674.9 6,376.5 17.9% 24,052.0

Year 3
8,143.6 -2,850.3 11,250.0 -188.3 0.0 16,355.1 897.2 17,252.3 17,252.3 34,168.8 8,086.9 17.4% 20,147.8

Year 4
10,804.8 -3,781.7 11,250.0 -204.3 -56,193.2 -38,124.3 583.7 -37,540.6 -37,540.6 76,682.7 3,627.1 16.4% 19,826.3

Year 5
10,662.1 -3,731.7 14,048.3 6,265.3 0.0 27,243.9 2,285.4 29,529.3 57,896.2 87,425.6

59,143.5 25,878.1

24,039.5 21.3%

25,878.1

11

CFD is derived from module 2 in the CB.

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Now we can compare the different results. We take as reference the firm and equity values calculated when excess cash is invested in all cases (second line versus first line). In the same way, 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). Table 11: Differences between methods
Firm value Equity value Firm value using current practice 56,554.5 Equity value Difference Difference qith current in firm in equity practice value value

With cash excess invested All cash excess is distributed and reflected in the financial statements Difference

54,374.4

21,109.0

23,289.1

4.01%

10.33%

57,276.1 5.34%

24,010.8 13.75%

59,143.5 4.58%

25,878.1 11.12%

3.26%

7.78%

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. 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 prctica prctica corriente 56,554.5 23,289.1 4.01% 10.33% 59,143.5 8.77% 25,878.1 22.59%

With cash excess invested All cash excess is distributed and reflected in the financial statements

54,374.4 0.00% 57,276.1 5.34%

21,109.0 0.00% 24,010.8 13.75%

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, for instance) are relevant, mainly when we observe the amounts related to the equity value. (and this is what finally we are

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looking for) In the case of the firm value these differences are 4.01% and 8.77%; in the case of equity differences are 10.33% and 22.59%. These differences are significant.

CONCLUDING REMARKS We have shown some arguments against the current practice of including in the CFE items that are not cash flows. In fact, they belong to the BS. 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. In that case, 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. In summary: the CFE should reflect exactly what is paid to the equity holders. In case that it is decided to distribute all the available cash, that fact should be reflected in the financial statements. On the other hand, we have shown how when considering amounts that are not cash flows we overvalue the firm value and specially, the equity value. BIBLIOGRAPHIC REFERENCES

Benninga, Simon Z. and Oded H. Sarig, Corporate Finance. A Valuation Approach, McGraw-Hill, 1997 Brealey, Richard and Stewart C. Myers, 2003, Principles of Corporate Finance, 7th edition, McGraw Hill-Irwin, New York. Copeland, Thomas E., Koller, T. and Murrin, J., Valuation: Measuring and Managing the Value of Companies, 2nd Edition, John Wiley & Sons1995. Copeland, Thomas E., Koller, T. and Murrin, J., 2000, Valuation: Measuring and Managing the Value of Companies, 3rd Edition, John Wiley & Sons, (July 28). Damodaran, Aswath, 2007, www.stern.nyu.edu/~adamodar/pdfiles/eqnotes/packet1.pdf visited on Octubre 30. Faulkender, Michael W. and Wang, Rong, 2004, "Corporate Financial Policy and the Value of Cash" (July 23). Available at SSRN: http://ssrn.com/abstract=563595

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Harford, Jarrad, 1999, "Corporate Cash Reserves And Acquisitions" Journal of Finance, Vol. 54, No. 6, p. 1969-1997. Available at SSRN: http://ssrn.com/abstract=2109 or DOI: 10.2139/ssrn.2109, (January 30, 1997). Jensen, Michael C., 1986, "Agency Cost Of Free Cash Flow, Corporate Finance, and Takeovers". American Economic Review, Vol. 76, No. 2, pp. 323-329. May Available at SSRN: http://ssrn.com/abstract=99580 or DOI: 10.2139/ssrn.99580 Lorie, J. H. y L. J. Savage, 1955, Three Problems in Rationing Capital, Journal of Business, Vol. XXVIII, Octubre. En Solomon, E. (Ed), 1959, The Management of Corporate Capital, The Free Press of Glencoe, Illinois. Mikkelson, Wayne H., 2003, "Do Persistent Large Cash Reserves Lead to Poor Performance?", Journal of Financial and Quantitative Analysis Vol. 38, n 2, June, p. 275-294. Available at SSRN: http://ssrn.com/abstract=186950 or DOI: 10.2139/ssrn.186950 Miller, M. H. and F. Modigliani, 1961, Dividend Policy, Growth and the Valuation of Shares, The Journal of Business, V. 34, No. 4, P. 411-433 (Oct). Opler, Tim C., Pinkowitz, Lee Foster, Stulz, Ren M. and Williamson, Rohan G., 1999, "The Determinants and Implications of Corporate Cash Holdings", Journal of Financial Economics, Vol. 52, Iss. 1, p: 3-46. as NBER Working Paper No. W6234. Available at SSRN (October 1997): http://ssrn.com/abstract=225992 Pinkowitz, Lee Foster, Stulz, Ren M. and Williamson, Rohan G., 2003, "Do Firms in Countries with Poor Protection of Investor Rights Hold More Cash?" (November). Dice Center Working Paper No. 2003-29. Available at SSRN: http://ssrn.com/abstract=476442 or DOI: 10.2139/ssrn.476442 Pinkowitz, Lee, Rohan Williamson and Ren M. Stulz, 2007, Cash Holdings, Dividend Policy, and Corporate Governance: A Cross-Country Analysis, Journal of Applied Corporate Finance, Vol. 19 N. 1, Winter. Pinkowitz,Lee, and Williamson, Rohan G., 2002, "What is a Dollar Worth? The Market Value of Cash Holdings" (October). Available at SSRN: http://ssrn.com/abstract=355840 or DOI: 10.2139/ssrn.355840 Schwetzler, Bernhard and Reimund, Carsten, 2003, "Valuation Effects of Corporate Cash Holdings: Evidence from Germany". HHL Working Paper. Available at SSRN: http://ssrn.com/abstract=490262 Tham, Joseph y Vlez-Pareja, Ignacio, 2004, Principles of Cash Flow Valuation, Academic Press. Vlez-Pareja, Ignacio, 1999, "Construction of Free Cash Flows: A Pedagogical Note. Part I" (December). http://ssrn.com/abstract=196588. Vlez-Pareja, Ignacio, 1998. Decisiones de Inversin, una aproximacin al anlisis de alternativas. CEJA. Vlez-Pareja, Ignacio, Decisiones de Inversin. Enfocado a la Valoracin de Empresas, 4ed 2004, CEJA. Vlez-Pareja, Ignacio, Evaluacin Financiera de Proyectos de Inversin, 1994, Ministerio de Trabajo y Seguridad Social, Superintendencia del Subsidio Familiar, Colombia.

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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, 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. Actual dividends, however, 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, using a model that focuses only on dividends will under state the true value of the equity in a firm. Measuring Potential Dividends Some analysts assume that the earnings of a firm represent its potential dividends. This cannot be true for several reasons: o Earnings are not cash flows, since there are both non-cash revenues and expenses in the earnings calculation o Even if earnings were cash flows, a firm that paid its earnings out as dividends would not be investing in new assets and thus could not grow o Valuation models, where earnings are discounted back to the present, 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 - 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. Estimating Cash Flows: FCFE Cash flows to Equity for a Levered Firm Net Income - (Capital Expenditures - Depreciation) - Changes in non-cash Working Capital12 - (Principal Repayments - New Debt Issues) = Free Cash flow to Equity I have ignored preferred dividends. If preferred stock exist, preferred dividends will also need to be netted out

From slide 92 (Damodaran 95): In accounting terms, the working capital is the difference between current assets (inventory, cash and accounts receivable) and current liabilities (accounts payables, 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). Observe that investment of excess cash is not included in the definition of working capital.
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