term.Thus,dividendscanbeviewedasaflooronthecash
flow to equity.
Potential Dividends
While dividends areobservable and require no estimation,
they arealso discretionary. Firms arenot required to pay
dividendsandmayverywellchoosenottopaydividendsor
topayverylittleindividendsevenwhentheyarecapableof
payingmore.Toestimatehowmuchcashafirmcanaffordto
returntoitsstockholders,webeginwiththenetincome—the
accountingmeasureofthestockholders’earningsduringthe
period—andsubtractafirm’sreinvestmentneeds(defined,as
with cashflowto thefirm,as netcapitalexpendituresand
changes in noncash working capital). In addition, though,
equityinvestorshavetoconsidertheeffectofchangesinthe
levelsofdebtontheircashflows.Repayingtheprincipalon
existing debt represents a cash outflow; but the debt
repaymentmaybefullyorpartiallyfinancedbytheissueof
new debt, which is a cash inflow. Again, netting the
repaymentofolddebtagainstthecashinflowfromnewdebt
issuesprovidesameasureofthecashfloweffectsofchanges
in debt.
Allowingforthecashfloweffectsofnetcapitalexpenditures,
changesinworkingcapital,andnetchangesindebtonequity
investors,wecandefinethecashflowsleftoverafterthese
changes as the free cash flow to equity (FCFE).