Once More, the Correct Definition for the Cash Flows to Value a Firm (Free Cash Flow and Cash Flow to Equity)

22 Pages Posted: 3 Feb 2005 Last revised: 5 Aug 2013

See all articles by Ignacio Velez-Pareja

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Date Written: 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) and available at SSRN. 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 theThis 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) . 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 Vélez-Pareja (2004), Vélez-Pareja (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.

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

Keywords: 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

Suggested Citation

Velez-Pareja, Ignacio, Once More, the Correct Definition for the Cash Flows to Value a Firm (Free Cash Flow and Cash Flow to Equity) (October 28, 2007). Available at SSRN: https://ssrn.com/abstract=642763 or http://dx.doi.org/10.2139/ssrn.642763

Ignacio Velez-Pareja (Contact Author)

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
Cartagena
Colombia
+573112333074 (Phone)

HOME PAGE: http://cashflow88.com/decisiones/decisiones.html

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