THE CORRECT DEFINITION FOR THE CASH FLOWS TO VALUE A FIRM

(FREE CASH FLOW AND CASH FLOW TO EQUITY)

Ignacio VlezPareja
Politcnico Grancolombiano
Bogot, Colombia
ivelez@poligran.edu.co
I wish to thank the comments received from Juan Carlos Gutirrez (juancg@proteccion.com.co) y Ricardo
Botero (rbgstocks@hotmail.com)

First version: August 21, 2004

This version: January 17, 2005

ABSTRACT
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

ii

THE CORRECT DEFINITION FOR THE CASH FLOWS TO VALUE A FIRM

(FREE CASH FLOW AND CASH FLOW TO EQUITY)

INTRODUCTION
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.
Vlez-Pareja (1994, 1997, 1999, 2004) and Tham y Vlez-Pareja, 2004 have
insistently expressed the idea that the most straightforward approach to derive the cash
flows is starting from the cash budget1.

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.

Some Considerations Regarding the Typical Practice

Some respected authors (Copeland, et al, Benninga et al.2 and Damodaran) support
the idea that the CFE has to include potential dividends.3 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).4
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

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.
3
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.
4
See the transcription of the relevant slides in the Appendix

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.
3. The same idea of Modigliani and Miller, M&M 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.
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.
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.
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 EXAMPLE5
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
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.

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

Table 1. Cash Budget, CB when payout ratio is 100% and any excess cash in invested in
market securities.
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 0
Year 1 Year 2 Year 3 Year 4
Year 5
-46,680.0 14,556.7 15,051.9 17,042.6 -38,880.0 20,839.5
16,616.6
0.0

0.0

0.0

30,944.6
0.0

2,756.9

3,323.3
0.0
0.0
3,453.6
3,650.6
4,129.1

3,323.3
0.0
0.0
3,544.3
3,000.2
5,184.0

3,323.3
0.0
0.0
3,680.4
2,152.8
7,886.1

3,323.3
0.0
0.0
3,781.2
1,464.3
-16,504.2

3,323.3
6,188.9
0.0
3,877.7
4,270.4
5,936.0

0.0
0.0
4,129.1

0.0
0.0
5,184.0

1,032.3
0.0
6,853.9

3,701.7
0.0
-20,205.9

5,926.0
0.0
10.0

0.0 5,582.2 11,181.0

0.0
424.8
850.9
5,582.2 11,181.0 18,875.7
1,553.1 -1,453.1
10.0
10.0

18,875.7
1,340.2
0.0
10.0

0.0
0.0
0.0
10.0

130.0

140.0

16,616.6

0.0
-13,446.9

15,000.0
1,553.1
0.0
0.0

1,553.1

Now we show the Balance Sheet

100.0

110.0

120.0

Table 2. Balance Sheet, BS when payout ratio is 100% and any excess cash is invested in
market securities.
Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

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)

Check

1,553.1

100.0

110.0

120.0

130.0

140.0

0.0

2,404.2

2,577.0

2,791.0

3,008.5

3,239.3

1,680.0

1,933.0

2,190.5

2,221.8

2,365.0

2,449.7

0.0

5,582.2

11,181.0

18,875.7

0.0

0.0

3,233.1

10,019.3

16,058.4

24,008.5

5,503.5

5,829.0

45,000.0

33,750.0

22,500.0

11,250.0

56,193.2

42,144.9

48,233.1

43,769.3

38,558.4

35,258.5

61,696.6

47,973.8

0.0

1,781.9

2,043.5

2,669.7

2,841.8

2,290.8

0.0

0.0

0.0

0.0

0.0

2,756.9

0.0

1,781.9

2,043.5

2,669.7

2,841.8

5,047.6

16,616.6

13,293.2

9,969.9

6,646.6

34,267.9

24,755.7

16,616.6

13,814.5

10,633.0

7,360.8

3,781.2

0.0

33,233.1

28,889.7

22,646.5

16,677.2

40,891.0

29,803.3

15,000.0

15,000.0

15,000.0

15,000.0

15,000.0

15,000.0

0.0

-120.3

911.9

3,581.3

5,805.6

3,170.5

48,233.1
68.90%

43,769.3
61.93%

38,558.4
53.43%

35,258.5
39.73%

61,696.6
61.67%

47,973.8
57.35%

0.0

0.0

0.0

0.0

0.0

0.0

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
0.0
0.0
0.0
0.0
Repurchase of shares
0.0
0.0
1,032.3
3,701.7 5,926.0
CFE
0.0
0.0
1,032.3
3,701.7 5,926.0
TV debt
24,376.2
CFE with TV for CFE
0.0
0.0
1,032.3
3,701.7 30,302.2
Ke
21.42%
18.97%
17.55% 16.02% 17.75%
Levered equity
15,548.9 18,879.1 22,460.3 25,369.8 25,733.5
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).

Firm and equity values (calculation not shown): Firm value is 48,782.0 and Equity
equals to Firm value minus debt is 15,548.9
In this case the D% is below 70% for all years. In the example the critical level of
leverage is 85%. Beyond that level growth and AP conditions start to be affected.
Table 4. Cash Budget, CB when layout ratio is 100% and any excess cash is paid to the
equity holder.
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 0
Year 1
Year 2
Year 3
Year 4
Year 5
-46,680.0 14,556.7 15,100.6 16,624.1 -38,940.1 21,083.9
16,616.6
50,579.1
0.0

0.0

0.0

4.1

7,427.4

3,323.3
0.0
0.0
3,453.6
3,650.6
4,129.1

3,323.3
0.0
0.0
3,544.3
3,000.2
5,232.7

3,323.3
0.0
0.0
3,680.4
2,152.8
7,471.7

3,323.3 3,323.3
0.0 10,115.8
4.1
0.0
3,781.2 3,877.7
1,464.8 6,528.4
3,065.6 4,666.0

0.0
5,582.2
-1,453.1

0.0
5,222.7
10.0

738.4
6,723.3
10.0

3,055.1
0.5
10.0

4,654.9
1.2
10.0

1,553.1

0.0
0.0
0.0
-1,453.1

0.0
0.0
0.0
10.0

0.0
0.0
0.0
10.0

0.0
0.0
0.0
10.0

0.0
0.0
0.0
10.0

1,553.1

100.0

110.0

120.0

130.0

140.0

16,616.6

0.0
-13,446.9
15,000.0
1,553.1
0.0
0.0

Next we show the Balance Sheet

Table 5. Balance Sheet, BS when payout ratio is 100% and any excess cash is paid to the
equity holder
Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

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)

Check

1,553.1

100.0

110.0

120.0

130.0

140.0

0.0

2,404.2

2,573.5

2,773.5

2,965.9

3,156.8

1,680.0

1,933.0

2,187.6

2,207.9

2,361.1

2,481.6

0.0

0.0

0.0

0.0

0.0

0.0

3,233.1

4,437.2

4,871.1

5,101.5

5,457.0

5,778.3

45,000.0 33,750.0 22,500.0 11,250.0 56,193.2 42,144.9

48,233.1 38,187.2 27,371.1 16,351.5 61,650.1 47,923.2
0.0

1,781.9

1,955.0

1,933.3

1,960.6

1,976.2

0.0

0.0

0.0

4.1

0.0

7,427.4

0.0

1,781.9

1,955.0

1,937.4

1,960.6

9,403.6

16,616.6 13,293.2

9,969.9

6,646.6 53,902.5 40,463.3

16,616.6 13,814.5 10,633.0

7,360.8

3,781.2

0.0

33,233.1 28,889.7 22,557.9 15,944.8 59,644.3 49,866.9

15,000.0

9,417.8

0.0

-120.3

4,195.1 -2,528.2
618.0

2,934.8

-2,528.7 -2,529.8
4,534.5

586.1

48,233.1 38,187.2 27,371.1 16,351.5 61,650.1 47,923.2

68.90% 70.99% 75.27% 85.69% 93.57% 99.93%
0.0

0.0

0.0

0.0

0.0

0.0

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
5,582.2
5,222.7
6,723.3
0.5
1.2
Repurchase of shares
0.0
0.0
738.4
3,055.1 4,654.9
CFE
5,582.2
5,222.7
7,461.7
3,055.6 4,656.0
TV debt
-5,070.8
CFE with TV for CFE
5,582.2
5,222.7
7,461.7
3,055.6
-414.8
Ke
22.81%
22.55%
23.20% 55.51% -74.73%
Levered equity
12,530.6
9,806.4
6,794.9
909.5 -1,641.2
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).
Firm and equity values (calculation not shown): Firm value is 45,763.6 and Equity
equals to Firm value minus debt is 12,530.5

10

In this case the D% is higher than the critical level for the last 3 years. The effect of
this is to reduce value as can be seen in the total value for the firm. (This is known as
bankruptcy costs).
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.
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.

BIBLIOGRAPHIC REFERENCES
Benninga, Simon Z. and Oded H. Sarig, Corporate Finance. A Valuation Approach,
11

McGraw-Hill, 1997
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., Valuation: Measuring and Managing the
Value of Companies, 3rd Edition, John Wiley & Sons, 2000 (July 28).
Damodaran, Aswath www.stern.nyu.edu/~adamodar/pdfiles/eqnotes/packet1.pdf visited on
May, 2004
Tham, J. and Vlez-Pareja, I., Principles of Cash Flow Valuation, Academic Press. 2004.
Vlez-Pareja, Ignacio, "Construction of Free Cash Flows: A Pedagogical Note. Part I"
(December 1999). http://ssrn.com/abstract=196588.
Vlez-Pareja, Ignacio, Decisiones de Inversin, una aproximacin al anlisis de
alternativas, 1998, CEJA.
Vlez-Pareja, Ignacio, Decisiones de Inversin, una aproximacin al anlisis de
alternativas (Versin preliminar), 1997, CEJA.
Vlez-Pareja, Ignacio, Evaluacin Financiera de Proyectos de Inversin, 1994, Ministerio
de Trabajo y Seguridad Social, Superintendencia del Subsidio Familiar, Colombia.
Vlez-Pareja, Ignacio, Decisiones de Inversin. Enfocado a la Valoracin de Empresas,
4ed 2004, CEJA.

12

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 Capital6
- (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
6

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.

13