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Critical Analysis of Free Cash Flow Theory

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Table of contents

  1. Introduction
  2. Free Cash Flow Theory
  3. Criticism

Introduction

The theory was proposed by Michael C. Jensen in an article called “Agency Costs of free cash Flow, Corporate Finance and Takeovers in 1986.”

According to this theory if a firm is efficient should pay the free cash flow to the shareholders. The firm should also give maximum value of the free cash flow to the shareholders. In the view of Jensen free cash flow is a problem rather than a good thing. When the firm has substantial free cash flow then the conflicts of interests between shareholders and management have become severe over payout policies. The problem is how to motivate managers to invest cash in cost of capital rather than waste it through organizational inefficiencies.

Free Cash Flow Theory

The theory proposed by Jensen in 1986. Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. If a firm produces considerable free cash flow then the conflicts of interest over payout policies become severe between shareholders and managers.

The purpose of the development of the theory is the benefits of debt in reducing agency costs of the free cash flows. How can dividends be the substitute of debt?

  • Assumptions
  • Excessive free cash flow leads to over-investment.
  • Managers are able to manipulate free cash flow under their control.
  • There is an assumption in most previous research that second-order important relative to investment decisions are dividends.
  • Earnings predictability negatively associated with surplus free cash flow.
  • Earnings management practices mitigate high-quality auditors.
  • The relationship between free cash flow in low growth companies and earnings management moderate by high-quality auditors.
  • Opportunistic behaviour of manager positively affected by free cash flow.
  • Dividend payout ratio negatively affected by free cash flow and investment opportunity set.
  • Investment opportunity set positively affected by free cash flow.
  • The free cash flow level can reduce by the contribution of the small size of the board of directors.
  • The free cash flow level can reduce by the presence of outside director’s contributions.
  • The free cash flow level reduces/increases by higher managerial ownership.
  • Among Malaysian firm’s earnings are the key determinants in explaining dividends smoothing.
  • The SFCF- earnings management relationship moderate by high-quality auditors.
  • The investment cash flow sensitively is negatively associated with the presence of a large family shareholder.
  • At moderate levels of shareholdings, the investment cash flow sensitively is positively associated with the family ownership percentage.
  • Literature Support

The results in Chen et al. (2012) show that cash holdings are inversely related to leverage and credit line access. This helps to alleviate the agency problem of FCF (Jensen, 1986).

Richardson (2006) finds a positive relationship between over-investment and FCF, which is consistent with the agency cost explanation.

Apedzan Emmanuel higher et al. (2014) expects a positive coefficient of FCF. A significant impact would support our hypothesis and would also indicate that firms make use of FCF to pay dividends. This will also support Jensen (1986) that managers try to reduce agency conflict by paying dividends to shareholders out of FCFs.

Chen et al. (2007) also affirm that dividend-paying firms have higher earnings persistence than no dividend paying firms.

Previous studies document that the relation between internal funds and the investment of firms is positively significant (Devereux and Schiantarelli, 1990; Fazzari et al., 1988; Kuh and Meyer, 1959).

Pawlnaand Renneboog (2005) provides strong support for the free cash flow theory as the main source of the observed investment-cash flow sensitivity.

Harjoto and JO (2011) provide adding support that firms use governance mechanisms, along with CSR engagement, to reduce conflicts of interest between managers and non-investing stakeholders.

Cheng et al. (2014) reveal that firms with superior CSR performance have better access to capital because of reduced agency costs resulting from more effective stakeholder engagement.

Early studies such as Griffin (1988) extend the general finance literature to oil industry firms and finds supporting evidence of FCF and prove that agency problem exists in the US energy industry.

Lang and Litzenberger (1989) find that the overinvesting firms have significantly larger return associated with announcements of large dividend increases, supporting the free cash flow hypothesis.

The findings of Rozeff (1982) and Easterbrook (1984) support the free cash flow hypothesis. According to these researchers, paying greater dividends can reduce firms' agency costs. As firms paying high dividends are financed more often by the market, they are subject to closer scrutiny.

According to Christie and Zimmerman (1991), paying out dividends is helpful for reducing free cash flow in the hands of company managers as well as reducing agency cost.

La Porta et al. (2000) found evidence that is consistent with the role of dividends in reducing the problem of agency.

Criticism

Chung et al. (2005) argue that these projects may support the self-interest of managers and may offer them a greater level of control over a firm’s resources.

Managers may thus undertake non-optimal actions such as value-destroying investments that result in increased agency costs, a reduction of firm value, and senior executives being pushed into a vulnerable situation. The worst case scenario is that managers can use opportunistic earnings management tools to inflate reported earnings for the purpose of obscuring the devastating effect of such value-destroying investments (Bukit and Iskandar, 2009; Chung et al., 2005; Rahman and Mohd-Saleh, 2008).

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Chung et al (2005) argue that company managers with surplus free-cash-flow use income increasing discretionary accruals (DAC) to offset the low or negative earnings and that external monitoring is effective in deterring the manager's opportunistic earnings management.

Accordingly, as argued by Fresard and Salva (2010), when governance mechanisms are poor, self-interested managers have the ability to use corporate resources in favour of their own interests. Excess cash enables them to take actions that benefit themselves by spending on unprofitable investments. Because cash reserves are easier to expropriate than other assets, turning excess cash into personal benefits is easier than transferring other assets to private benefits (Myers and Rajan, 1998).

Overall, Belkhir et al. (2014) argue that independent boards seem to be effective in mitigating investors’ concerns about any misallocation of funds.

Morck et al. (1988) argue that high levels of managerial ownership could lead to entrenchment, as outside shareholders find it difficult to control the actions of such managers.

Lopez-Iturriaga and Lima (2014) criticize that the dividend policy plays an important role as a disciplining mechanism in the management of companies with low growth opportunities, given that the FCF reduces by the payment of dividends that managers can use at their own discretion.

Numerous scholars argue in reducing the agency costs of FCF dividends and managerial ownership maybe substitutes. (Rozeff, 1982; Jensen et al., 1992; Lee, 2011)

Charitou and Vafeas (1998) conducted a study on the association between operating cash flows and dividend changes, given earnings and argue that a positive relationship between and dividend changes should exist due to liquidity and accruals management considerations.

Brav et al. (2005) determine that management prefers to share repurchase to dividends because it allows management to retain more control over the timing of payout. The commitment to recurring dividend payout provides a restriction on overspending that is desirable for shareholders but not for management.

Under perfect and complete markets, the pattern of dividend payouts has no effect on the firm’s value (Miller and Modigliani).

Benabou and Triole (2010) and Eccles et al. (2012) argue that high sustainability companies are more likely to establish a formal stakeholder engagement process which limits the likelihood of short-term opportunistic behaviour.

Chung et al. (2005) suspect that bias managers may not even internally project cash flows for some investments as they have for some pleasure activities or personal need that make them ignore cash and profit projections. However, they believe that poor investments will reveal themselves in the future reported profits of the company and argue that non-value-maximizing investments will eventually reduce earnings.

Gilchrist and Himmelberg (1995) criticized that Tobin's Q has low explanatory power and is an insufficient measure of investment opportunities.

Dhrymes and Kurz (1967) argue that a stable dividend policy hampers investment through the reduction of internal capital, whereas firms with residual dividend policy first cut dividends firm investment needs.

Rubin (1990) and Lang, Stulz, and Walkling (1991) criticize that managers prefer to use any free cash flow remaining after investment negative-NPV projects to continue to invest in such projects rather than pay out dividends.

Brush, Bromiley, and Hendrickx (2000) found that growth negatively impacted by free cash flow.

While Titman et al. (2004) and Fairfield et al. (2003) found overinvestment problems with a much lower stock performance among firms.

Similarly, Dechow et al. (2008) proposed that firms with excessive free cash flow had lower future performance.

Easterbrook (1984) argued that dividends can discipline the company by issuing back to the capital market for future funds, thus allowing investors to control the company.

Vogt (1994) argues that large non-growth firms conform more to the free cash flow agency theory, whereas small-growth firms conform more to the pecking order theory.

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Critical Analysis of Free Cash Flow Theory. (2022, September 27). Edubirdie. Retrieved March 3, 2024, from https://edubirdie.com/examples/critical-analysis-of-free-cash-flow-theory/
“Critical Analysis of Free Cash Flow Theory.” Edubirdie, 27 Sept. 2022, edubirdie.com/examples/critical-analysis-of-free-cash-flow-theory/
Critical Analysis of Free Cash Flow Theory. [online]. Available at: <https://edubirdie.com/examples/critical-analysis-of-free-cash-flow-theory/> [Accessed 3 Mar. 2024].
Critical Analysis of Free Cash Flow Theory [Internet]. Edubirdie. 2022 Sept 27 [cited 2024 Mar 3]. Available from: https://edubirdie.com/examples/critical-analysis-of-free-cash-flow-theory/
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