Discussion paper series - distributable cash flows in the corporate valuation

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Discussion Paper Series : Distributable Cash
Flows in the Corporate Valuation
Discussion:
Ignacio Velez-Pareja (IVP):
Dear Karnen,
I have a question: which is the proper way to calculate the return of a stock (just as needed to
run a regression with market return to find beta). I think it is
Rs_t = [(P_t + Div_t)/P_t-1] - 1
where P is price and Div is dividends.
Am I missing something? What do you think?
Sukarnen
DILARANG MENG-COPY, MENYALIN,
ATAU MENDISTRIBUSIKAN
SEBAGIAN ATAU SELURUH TULISAN
INI TANPA PERSETUJUAN TERTULIS
DARI PENULIS
Untuk pertanyaan atau komentar bisa
diposting melalui website
www.futurumcorfinan.com

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Karnen:
Yes, that's correct unless there is stock split. Capital gain plus dividend yield.
IVP:
Perfect!
Do you see any cash distribution, real or virtual? I don't. Hence, to model the NWC (= Net
Working Capital) assuming implicitly that any increase/decrease in cash is distributed to
shareholders is not correct and is not consistent with CAPM and the like!!!
What you do wrongly assuming that distribution is called by some people (Damodaran (note:
Prof. Aswath Damodaran) among them) as Potential Dividends. Why? Because they are not
distributed in reality. They are a fiction. And yet, Damodaran uses the formula we have agreed
to estimate betas without assuming that fictitious distribution of cash.
Follow?
Karnen:
Dear Ignacio,
Using cash flows always creates many interpretations. I will send you tomorrow one article
listing various ways in defining cash flows.
This is why Stern & Co uses FCFF = Free Cash Flows To the Firm. It is distributABLE cash
flows either to debtholders and/or equity holders.
Ok forget that....
Use earnings as Stephen Penman (note: Prof. Stephen Penman) suggested. Started with book
value then plus value added along the way.

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This will reduce the headache with that potential or real.
IVP:
Dear Karnen,
I look forward to the papers you offered. Thanks!
The headache you mention is crystal clear solved with my approach: consider CFs the funds
you expect to pay to debt and equity holders. No headache, no confusion, no interpretation. No
room for discussion. What else can you expect?
When I forecast the financial statements and from there the cash flows, those cash flows are the
ones I need to comply with in the future. That CFs doesn’t include fake CFs, but yes, the
illusions created by N assumptions on what will happen in the future. If you can arrive to that
CFs, why the interest in including what is not distributed?
On the other hand, I am not against distributing all cash available, Great to do that and it ir will
increase value. BUT if you suggest distributing ALL that cash, DO IT! Reflect that decision in the
financial statements. That is all I ask the analyst. No more, no less.
Karnen:
Hi Ignacio,
Please find enclosed the paper published in the CPA Journal (2002) about so many ways in
defining Free Cash Flows (“Defining Free Cash Flow” by John Mills, Lynn Bible and Richard
Mason. http://www.nysscpa.org/cpajournal/2002/0102/features/f013602.htm).

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I don't say, I don't agree with your approach. Yet, just claiming that's "cash flows to the
shareholders" and "cash flows to the debtholders" by tracking through the cash budget, doesn't
mean that it is always correct for valuation purposes. That cash flow is the product, so we need
to look at the process behind that product. It is clear to me that to get that CFE and CFD, you
put the changes of excess cash in the NWC. This is not always correct. In reality, which excess
cash can go to anywhere, and for 100%, it is not for NWC. We learnt from Microsoft, Apple, etc,
they used that excess cash for acquisition (cash deal makes the acquisition decision faster!),
and later stock buybacks, bonus and dividends.
IVP:
Whatever you decide to do with excess cash, include it into de the CB (= Cash Budget) and IS
(= Income Statement) and BS (= Balance Sheet). If you plan to buy another firm, or buy
inventory, do it and include that in the CB. The problem is eliminating it from the WC (= Working
Capital) and still keeping it in the BS as marketable securities, because when you do that the
result is to increase artificially the CF to equity. I insist. Whatever you plan to do with excess
cash, include it into the financial statements: CB, IS and BS. No more, no less.
What you shouldn't do is to assume happily that it is distributed to shareholders WITHOUT
listing that decision in the Financial Statements.
That's all.
Karnen:
Sure Ignacio, I learnt much from this "heavy-charged" discussions. At least this made me think
hard.
Excess cash should be defined for what purposes. We can't just net it off against debt as many
books (including Berk and Peter DeMarzo's corporate finance textbook, both are professor of
finance in Stanford) to get what they call "net debt". I have seen analysts doing this, but at the
same time, they don't make necessary adjustment for this excess cash (that in reality, earning
marginally low interest rate) to the WACC.

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Theoretically, WACC should be kd(after tax) + ke + k_excess cash.
Your basic message didn't shoot into my head, since it seems to me you keep saying about
CFE (= Cash Flow to Equity holders) and CFD (= Cash Flows to Debtholders). However, your
email above dawns on me that you are more concerned about detailing the plan of excess cash
and reflect that plan into CB, IS and BS ultimately.
IVP:
Yes, I am concerned on that but it is not something innocuous. See my comment in the blog.
When you don't do that, some indexes could fall down, as I say there, for instance, total
leverage that is what many lenders look to make the decision to lend money. If you make
decisions on excess cash without looking the possible positive or negative effect of that, you
assume the risk of doing something that impairs the firm/project to receive fresh money from
banks or lenders in general.
In our model we use for consulting we keep track of D% (total liabilities/Total assets). Hence, if I
decide to distribute 100% of excess cash (that in the right side is shown in retained earnings
that clearly affects equity book value and D%) it may result on a D% too high and the project will
risk the possibility of receiving new loans. Follow?
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