Thereareseveralcaseswhere thetwomodelswillprovide
differentestimatesofvalue.First,whentheFCFEisgreater
than the dividend and the excess cash either earns
below-market interest rates or is invested in negative net
presentvalueassets,thevaluefromtheFCFEmodelwillbe
greater than the value from the dividend discount model.
Thereis reason tobelieve thatthis isnot as unusualas it
wouldseemattheoutset.Therearenumerouscasestudiesof
firmsthat,havingaccumulatedlargecashbalancesbypaying
outlowdividendsrelativetoFCFE,havechosentousethis
cash to finance unwise takeovers(where theprice paid is
greaterthanthevaluereceivedfromthetakeover).Second,
thepaymentofdividendslessthanFCFElowersdebt-equity
ratiosandmayleadthefirmtobecomeunderlevered,causing
a loss in value.
InthecaseswheredividendsaregreaterthanFCFE,thefirm
will have to issue either new stock or debt to pay these
dividendsorcutbackonitsinvestments,leadingtoatleast
one of three negative consequences for value. If the firm
issuesnewequitytofunddividends,itwillfacesubstantial
issuancecosts thatdecrease value.If thefirmborrows the
money to pay the dividends, the firm may become
overlevered(relativetowhat’soptimal),leadingtoalossin
value. Finally, if paying too much in dividends leads to
capitalrationingconstraintswheregoodprojectsarerejected,
therewillbealossofvalue(capturedbythenetpresentvalue
of the rejected projects).
There is a third possibility, and it reflects different
assumptions about reinvestment and growth in the two
models. If the same growth rate is used in the dividend
discount and FCFE models, the FCFE model will give a