UPDATE 1-Peugeot family approves draft Dongfeng deal - sources
* Peugeot family boards approve Dongfeng deal -sources
* EPF, FPP holdings clear way for share sale -sources (Adds details, background)
By Gilles Guillaume and Laurence Frost
PARIS, Feb 17 (Reuters) - PSA Peugeot Citroen's founding family gave the go-ahead on Monday for a 3 billion euro ($4.1 billion) tie-up with China's Dongfeng that would draw a line under one of France's oldest industrial dynasties, sources said.
The boards of Peugeot family holding Etablissements Peugeot Freres and its FFP subsidiary signed off on the capital increase plan to be announced by the French carmaker on Feb. 19, two people with knowledge of the meetings said.
The two holding companies approved "all of the proposals" negotiated with Dongfeng and the French state, one source said.
Peugeot and Dongfeng Motor Group have been in talks for months over a rescue deal that would see the Chinese automaker and French government take matching 14 percent stakes. The plan is due to be approved by Peugeot's own board on Tuesday and announced the following day, sources have said.
A separate agreement to create a European sales financing alliance with Banco Santander is due to be unveiled simultaneously, according to people with knowledge of the plans.
A Peugeot spokesman declined to comment on the discussions.
Among the worst casualties of Europe's six-year market slump, Peugeot is being kept afloat by 7 billion euros in state guarantees to its sales financing arm that expire next year.
Under the deal, Peugeot plans to sell new stock to Dongfeng and the French state priced at 7.50 euros, a 41 percent discount on Monday's 12.79 euro closing price, followed by a rights issue to existing shareholders, sources have said.
For the Peugeot clan, the deal marks the end of a long road that began with the company's 1810 foundation as a maker of tools and coffee grinders.
The family's 25 percent stake and 38 percent of voting rights would be diluted to parity with the government and Dongfeng, short of the one-third required to veto decisions.
The proposed Dongfeng deal has divided the family, pitting Chairman Thierry Peugeot against cousin Robert, who heads FFP.
In a letter to Robert, leaked to French media, Thierry pushed an alternative plan to raise cash on the market and inject more family money. But he failed to win board support and abstained from votes to pursue the talks.
The logic behind the deal has been questioned by some analysts and investors who suggest Peugeot could instead sell its lending arm or Faurecia parts division.
"PSA would ultimately be better off if it walked away from a Chinese deal," Bernstein Research analyst Max Warburton said in a Feb. 14 note.
The 3 billion euro capital increase would be accompanied by a warrants issue allowing current shareholders to buy additional stock worth up to a further 1 billion euros.
The deal, subject to shareholder approval, would see Peugeot and Dongfeng reinforce their existing joint venture and Chinese production, entering new Southeast Asian markets.
They also plan to co-develop technologies including the Peugeot's HybridAir transmissions, which save fuel by storing energy recovered from braking in a compressed gas cylinder.
The Peugeots' loss of control leaves just two European car dynasties at the wheel: the Quandts of BMW and the Agnellis, who clung to power at Fiat even as it absorbed larger U.S. rival Chrysler last month. ($1 = 0.7307 euros) (Additional reporting by Sophie Sassard in London, editing by David Evans)