Free Cash Flow

Any reader of murder mysteries knows that a criminal must have both motive and opportunity. The above discussion was about motive. Managers with only a small ownership interest have an incentive for wasteful behavior. For example, they bear only a small portion of the costs of, say, excessive expense accounts, and reap all of the benefits.

Now let's talk about opportunity. A manager can only pad his expense account if the firm has the cash flow to cover it. Thus, we might expect to see more wasteful activity in a firm with a capacity to generate large cash flows than in one with a capacity to generate only small flows. This very simple idea, which is formally called the free cash flow hypothesis, has recently attracted the attention of the academic community.17

A fair amount of academic work supports the hypothesis. For example, a frequently cited paper found that firms with high free cash flow are more likely to make bad acquisitions than firms with low free cash flow.18

The hypothesis has important implications for capital structure. Since dividends leave the firm, they reduce free cash flow. Thus, according to the free cash flow hypothesis, an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities. Furthermore, since interest and principal also leave the firm, debt reduces free cash flow as well. In fact, interest and principal should have a greater effect than dividends have on the free-spending ways of managers, because bankruptcy will occur if the firm is unable to make future debt payments. By contrast, a future dividend reduction will cause fewer problems to the managers, since the firm has no legal obligation to pay dividends. Because of this, the free cash flow hypothesis argues that a shift from equity to debt will boost firm value.

In summary, the free cash flow hypothesis provides still another reason for firms to issue debt. We previously discussed the cost of equity; new equity dilutes the holdings of managers with equity interests, increasing their motive to waste corporate resources. We now state that debt reduces free cash flow, because the firm must make interest and principal payments. The free cash flow hypothesis implies that debt reduces the opportunity for managers to waste resources.

What are agency costs?

Why are shirking and perquisites considered an agency cost of equity?

How do agency costs of equity affect the firm's debt-equity ratio?

What is the free cash flow hypothesis?

17The seminal article is Michael C. Jensen, "Agency Costs of Free Cash Flow, Corporate Finance Takeovers," American Economic Review 76 (1986), pp. 323-39.

18L. Lang, R. Stulz, and R. Walkling, "Managerial Performance, Tobin's Q and the Gains in Tender Offers," Journal of Financial Economics (1989).


Ross-Westerfield-Jaffe: I IV. Capital Structure and I 16. Capital Structure: Limits I I © The McGraw-Hill

Corporate Finance, Sixth Dividend Policy to the Use of Debt Companies, 2002


438 Part IV Capital Structure and Dividend Policy

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    Why the Attention to Free Cash Flow?
    7 years ago
  • barbara
    Why does the free cash flow hypothesis provide a reason for firms to issue debt?
    7 years ago
  • diamanda
    What the free cash flow hypothesis states?
    6 years ago

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