equityreinvestmentratestocomputeterminalvalues,which
is a common practice, will have the same effect.)
2.Thecashnotpaidoutasdividendsisassumedtoearnthe
costofequityandthusisvalueneutral.Inotherwords,the
excess cash is invested in zero net present value investments.
Thesecond assumptionis a critical one.One concern that
investorshavewithfirmsthatbuildupcashbalancesisthat
the cash can be used to fund poor acquisitions. In other
words,thecashcanbeinvestedinnegativenetpresentvalue
investments. If, for instance, we assume in the preceding
examplethatthecash buildupwasinvestedtoearn7%(in
riskyinvestmentswithacostofequityof9%),thefollowing
tablesummarizes thecash buildupover timeinmillions of
dollars:
Addingthepresentvalueofthecumulatedcashbuildupatthe
endofthefifthyeartotheDDMvaluenowyieldsavaluefor
equity that is lower than the FCFE model:
Thelossinvalueof$9.26millionrelativetotheFCFEmodel
can be attributed to the firm’s negative net present value
investments.