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Free Cash Flow Essay

Jensen & Meckling (1976) study agency costs and suggest that a decreasing leverage results in the manager’s equity stake becoming diluted so his benefits of the firm’s financial success are reduced, so to maximise his utility he appropriates the firm’s resources in the form of perquisites. On the other hand, increasing leverage causes the manager’s equity stake in the firm to go up and hence motivates him to take fewer perquisites. However, leverage may also provide the manager an incentive to shift risks by taking riskier projects, which ultimately reduces firm value. Jensen (1986) investigated into the problems caused by wrong investment decisions by managers in order to utilise the free cashflow at their disposal.

Although managers are supposed to return the free cashflow back to the owners in the form of dividends or debt interest payments, they are motivated to invest in the remaining negative NPV projects for reasons such as expanding the business empire further or gaining personal experience by trial and error. This suggests that having excessive free cashflow can be detrimental to the value of the firm.

Jensen also feels that debt is beneficial to the firm as it binds the manager to interest payments periodically and hence

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reduces the free cashflow at his disposal. He also suggests that different amounts of the free cashflow are required by the firm according to the respective stages of its development. Firms which are young require making higher investments in order to tap the market when compared to more established firms.

This highlights the importance of the investment decisions of firms, as taking negative NPV projects can trade off the benefits of taking a positive NPV project and reduce firm value in the future. The investment decision a firm makes today impacts that cashflows of future years and therefore further impacts the prospects of the firm. Stulz (1990) talks about a free cashflow model which would contain just enough debt to provide sufficient free cashflows required to invest in the positive NPV projects. This way, the manager of the firm would only be left with just enough free cashflow to invest in all the positive NPV projects and hence benefit the firm.

In reality, investors are generally very rational and undertake close observation of the firm and its actions. Every decision of the firm is interpreted as a signal of its performance in the near future as it is an accepted fact that information is not symmetrically distributed between the managers and investors. Myers and Majluf (1984) describe the issuance of equity as a signal to the investors. Rational investors think that if a manager feels that the equity is undervalued in the market, he will not issue stock as that would fetch him the undervalued market price. On the other hand, if the manager feels that equity is overvalued, he will issue stock in order to tap the market of the excess value.

This provides a signal to the investors about a grim state in the future and therefore leads to fall in the market value of equity. Ross (1977) describes the signalling role of debt issuance and its relation to bankruptcy. A manager with poor confidence in the firm will not take on a high level of debt as he would not be able to repay it. That may lead the firm to bankruptcy and eventually manager would lose his job. A manager with high ability and confidence about the prospective growth of the firm will issue a high amount of debt showing his optimism.

Capital structure and investment mistakes have resulted in the downfall of various multinational companies such as Enron (too complex capital strategy goes out of control) and BT, all this in spite of various theories such as the Pecking order theory, signalling and debt as a disciplinary device all attribute to factors encouraging firms to finance through debt, along with Miller & Modigliani’s proposition incorporating tax. Jensen & Meckling’s influential discussion of agency costs addresses the need to trade off the costs associated with both high and low debt levels to develop an optimum leverage level.

The intricate details associated with capital structure decision making will vary within industries and between firms, making it impossible to generate a standardised scientific model. The factors mentioned play key roles in understanding the influencing factors but by no means can provide a definitive answer to this issue. The optimal capital structure is subject to change and flexibility and is usually never static. To conclude with the words of Myers (1998), the optimal mix of debt and equity varies from firm to firm, or industry to industry, and therefore should be considered on a case by case basis.

Bibliography

Fairchild, R., (2003). “An Investigation of the Determinants of BT’s Debt Levels from 1998-2002: What does it tell us about the Optimal Structure?” Working Paper Series. University of Bath School of Management, UK.

Jensen, M. (1986). “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers.” American Economic Review 76, 323-339

Jensen, M. and W.Meckling. (1976). “Theory of the firm: Managerial Behaviour, Agency Costs, and Capital Structure.” Journal of Financial Economics 3, 305-360

Modigliani, F., and M.Miller. (1958). “The Cost of Capital, Corporation Finance and the Theory of Investment.” American Economic Review 48, 261-297

Myers, S. “Still Searching for Optimal Capital Structure,” in The Revolution in Corporate Finance, edited by J.M. Stern and D.h. Chew Jr. (Blackwell Publishers 1998).

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