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The Economic Research Institute, Stockholm School of Economics SSE/EFI Working Paper Series in Business Administration

No 2011:6:
The Conventional Formula for the Nominal Growth Rate of Free Cash Flows is OK -- A Comment on Three Recent Papers in the Journal of Applied Corporate Finance

L. Peter Jennergren ()

Abstract: The conventional formula for the nominal growth rate of free cash flows (equal to dividends when there is no interest-bearing debt) says that this growth rate is equal to the product of the plowback ratio and the nominal rate of return on the assets (the latter equal to book equity when there is no debt). In a recent issue of the Journal of Applied Corporate Finance, M. Bradley and G. A. Jarrell claim that the conventional formula is wrong when there is positive inflation, proposing instead an alternative formula. In a rejoinder to that paper in the same journal, G. Friedl and B. Schwetzler assert that the conventional formula is right. In a comment on Friedl and Schwetzler, Bradley and Jarrell reassert their original position, that is, the conventional formula is wrong and the alternative one is right. This note shows that the conventional formula is right and that both formulas give the same nominal growth rate. Consequently, both are OK.

Keywords: Gordon formula; nominal growth rate; free cash flows; (follow links to similar papers)

9 pages, November 25, 2011

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