Choice of Models

P.V. Viswanath

Valuation of the Firm

DDM vs FCFE
Both DDM and FCFE are focused on
valuing equity directly.
FCFE is defined as the residual
cashflow that could be paid out to
shareholders as dividends without
affecting future cashflows
If so, dividends should equal FCFE
Then, why might the two reach
different conclusions?

DDM vs FCFE
There might be various reasons why a firm
might decide to pay more or less dividends
than the FCFE per share.
In a complete model, these uses for cash
should also be incorporated. However, to
the extent that the model is incomplete,
these additional uses of cash should be
taken into account outside the model.
If an FCFE model is used for valuation,
then adjustments to value should be made
to compensate for deviations between
potential dividends (from an FCFE
perspective) and actual optimal dividends.

Reasons to pay more or less

dividends
Desire for stability
Future Investment Needs
Tax factors
Signaling
Managerial Self-interest

Adjustments to FCFE Value

If dividends differ from FCFE
because management chooses to
keep dividends stable, this may not
affect firm value, except to the
extent that higher idle cash levels
may be maintained .
In this case, we would compute the
value of the firm using a FCFE model
and then adjust value downards.

Adjustments to FCFE Value

If dividends paid are lower because
cash is kept aside for future
investment needs, then the value to
the firm of cash in hand may be
greater than the actual exchange
value of the cash.
In this case, we could compute equity
value using FCFE and then add back
an additional amount to adjust for this
incremental value of cash.

Adjustments to FCFE Value

If managerial self-interest causes higher
than optimal values of cash to be kept on
hand, and correspondingly lower levels of
dividends to be paid out, an FCFE approach
would overstate the value of the firm under
current management.
However, the FCFE valuation would be
useful if the analyst believes that the firm
might be ripe for a takeover.
In this case, the manager would take a
weighted average of the dividend and the
FCFE approaches, weighting the FCFE
value by the probability of the firm being
acquired.

FCFE vs DDM
If we are going to use an FCFE approach and
then adjust up or down, why not start with
the DDM method and adjust down or up?
The FCFE approach explicitly relates the
cashflows to the underlying accounting
decision variables, such as leverage, net
working capital; marketing decisions such as
higher profit margin versus higher volume;
and macro variables such as the growth rate
of the economy and the sector.
The analyst is therefore forced to make all of
his/her assumptions explicit.
This ensures that no unwitting false
assumptions are being made.

FCFE vs. FCFF

Basic accounting principles imply
that the sum of equity and debt
(interpreted broadly to include other
liabilities as well) equals the value of
the firm.
In principle, then, the two
approaches should lead to the same
equity valuation.
If so, how do we choose between the
two?

FCFE vs FCFF
If a firm can be expected to change
its capital structure in the future in
an unpredictable or complex way,
then FCFF might be a better
approach.
If the value of debt is easy to
compute, then FCFF might be a
simpler way to approach the value of
the equity