Jensen (1986), who introduced the agency theory, has raised many issues that are fundamental to the literature. One of these is the hypothesis of free cash flows. Jensen defined free cash flows by the excess cash flows over what is required to finance all projects with positive net-present values discounted at relevant costs of capital. Chen et. Al (2011) found that free cash flows are an indicator for overinvestment. Theoretically speaking, free cash flow is a financial resource that the management can allocate at their discretion. It’s also called idle cash flow. Jensen’s (1986) argument also states that having a lot of free money has its consequences. It will lead to inefficiency and wasteful corporate resources, which leads to high agency costs. Jensen (1993), a researcher from the US, conducted a study on agency problems and required rates of return in the 1980s. The study concluded that the lack of required return on investment by US firms in 1980s was due to free cash flows.
Jensen suggests that the free cash flow model allows managers to control markets without having to pay dividends. Drobetz (et al.) (2010) stated that managers have a tendency to not pay cash dividends but they still invest, even though there are no investments with positive net-present value. This theory explains that managers want to accumulate funds to be able to control more resources and have the ability to make better investment decisions. To avoid disclosing detailed information, managers act with the firm’s funds.
Existing literature contains a large number of studies that explore the impact of free-cash flow on investment decisions and financial financing. These studies have largely confirmed Jensen’s theories and the agency issues in firms that have an excessive cash flow.
Prior research has been focused on reducing the agency cost problems of free-cash flow. Dividends are a prominent mechanism in the literature that counters the agency problem of free-cash flow. Myers, Agrawal, Knoeber, and Yilei (1996) found that a debt increase can help to solve the agency issue caused by cash flow. Fleming Heaney McCosker 2005 also echo this argument. They list some benefits associated with debt financing as a way to control and reduce agency costs. Grossman, Hart and Williams (1987) made the argument that financial leverage can influence managers to reduce agency costs by threatening liquidation. The threat of liquidation could cause managers to lose their compensation, esteem and benefits. This creates additional pressure on managers in terms of producing cash flow for the payment of interest expenses.
Rojeff, Easterbrook and others (1984) state that companies who pay dividends frequently are more likely to use capital markets as a source of financing. Oded (2007) states that while dividends can be flexible like debts, once the announcement is made, it becomes a contractual obligation to pay shareholders cash regularly. Consequently, the capital markets will be more closely monitoring the managers. The study concluded that firms forced to pay dividends are more likely to turn to the capital markets to finance excess funds, which reduces equity agency fees. Christie and Zimmerman found in 1991 that dividends could be helpful to managers when it comes to reducing their free cash flow. Their results revealed that dividends were able to create a mechanism of discipline and check managers without any intervention from shareholders.
Conflicts between principals and agents can be caused by a free cash flow, particularly in the case of dividends. Rubin (1990), Lang et. The study by Rubin (1990) and Lang et. Managers also use free cash flow to make unnecessary purchases aligned with personal interests. The manager can purchase tangible assets or intangible ones under the name of their firm, but the purpose is not to benefit the firm but rather for his personal use. According to free cashflow hypothesis, managers will be hesitant to borrow money or pay dividends if they reduce their own free cashflow.
According to the free cash flow theory, managers can pursue their personal goals by using cash generated internally in excess of projects with a net present value. This leads to increased agency costs, an unproductive allocation of resources, and a misguided decision to invest. There have been studies conducted to support the free cashflow hypothesis. However, the literature has mixed results.
Brush et. Al (2000) argued in support of the hypothesis that firms have less growth from sales when they have free money. Chung, et.al., (2005a), found out, on the contrary, that excessive cash flow has a negative impact on corporate profitability, and the stock market valuation. This is why they recommend the control theory of the institutional investor. Dechow and. The study by Dechow et. Rozef’s (1982), Easterbrook’s (1984), DeAngelo-DeAngelo 2000, La Porta-de-Silanes-Shleifer-Vishny (2000) and DeAngelo-DeAngelo’s (2000) studies also supported the free cashflow hypothesis. Titman Wei Xie (2004), Fairfield Whisenant Yohn (2003), and Titman Wei Xie (2000) are all examples of research that supports the free cashflow hypothesis.
But, different research has painted a very different picture. Gregory (2005) used UK data to find that mergers that had higher levels free cash flow performed better than mergers who did not. This reversal of the free cashflow hypothesis. Szewcyk Tsetsekos and Zantout 1996 Chan Chen Hsing and Huang 2007. Investors would favor companies that have large amounts of free money flow.
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