Agency Costs of Free Cash Flow
TL;DR: In this article, the authors identify the impact of unobservable FCF conflicts on firm policy using a structural approach and find that firms with large institutional holdings or better-aligned executive compensation suffer less from FCF agency conflicts.
Abstract: Free Cash Flow (FCF) agency conflicts exist when managers divert cash flow for private benefits. We identify the impact of unobservable FCF conflicts on firm policy using a structural approach. Measurement equations are constructed based on observable managerial choices: payout policy changes and personal portfolio decisions around exogenous tax rate changes. We find that FCF agency conflicts cause (i) under-leverage, leading to higher corporate taxes and (ii) under-investment in PP&E, leading to slower firm growth. Capital markets recognize FCF conflicts and discount such firms. Finally, firms with (i) large institutional holdings or (ii) better-aligned executive compensation, suffer less from FCF agency conflicts.
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TL;DR: In this paper, the authors highlight the paradoxes posed by novel exogenous shocks (that is, shocks that transcend past experiences) and the implications for SMEs and highlight how extreme environmental shocks and "black swan" events such as those caused by the coronavirus (COVID-19) pandemic and other global crises, can precipitate business failures.
171 citations
Cites background from "Agency Costs of Free Cash Flow"
...Although according to classical agency theory, corporate borrowing keeps management on a tight rein, forcing them to concentrate on returns rather than empire building (Jensen, 1986), it has been evident that proliferating debt is ultimately unsustainable....
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TL;DR: In this article, the authors analyzed the valuation implications of ERM maturity using data from the industry leading Risk and Insurance Management Society Risk Maturity Model over the period from 2006 to 2011, which scores firms on a five-point maturity scale.
Abstract: Enterprise Risk Management (ERM) is the discipline by which enterprises monitor, analyze, and control risks from across the enterprise, with the goal of identifying underlying correlations and thus optimizing the risk-taking behavior in a portfolio context. This study analyzes the valuation implications of ERM Maturity. We use data from the industry leading Risk and Insurance Management Society Risk Maturity Model over the period from 2006 to 2011, which scores firms on a five-point maturity scale. Our results suggest that firms that have reached mature levels of ERM are exhibiting a higher firm value, as measured by Tobin's Q. We find a statistically significant positive relation to the magnitude of 25 percent. Upon decomposition of the maturity score, we find that the most important aspects of ERM from a valuation perspective relate to the level of top–down executive engagement and the resultant cascade of ERM culture throughout the firm. Firms that have successfully integrated the ERM process into both their strategic activities and everyday practices display superior ability in uncovering risk dependencies and correlations across the entire enterprise and as a consequence enhanced value when undertaking the ERM maturity journey ceteris paribus.
162 citations
TL;DR: In this paper, the authors examined whether and to what extent CEO personal traits (hubris, in particular) affect firm environmental innovation and found that hubris facilitates the engagement in green innovative projects.
Abstract: This paper examines whether and to what extent CEO personal traits (hubris, in particular) affect firm environmental innovation. Using the overarching theoretical framework of upper-echelons theory, the paper builds on the insights from the corporate strategy, innovation, and corporate social responsibility literatures. We also examine the moderating role of firm-specific features (e.g. organizational slack) and the external environment (e.g. market uncertainty) in this context. Based on a sample of UK companies operating in sensitive industries, we find that CEO hubris facilitates the engagement in green innovative projects. We also find that CEO hubris does not have a uniform effect: its effect on environmental innovation increases with the organizational slack, but weakens with the extent of environmental uncertainty. Our findings suggest that availability of resources per se is not enough to produce environmental innovation. Instead, it requires a stable external environment that enables the CEO with a hubristic personality to make a correct use of them.
154 citations
Cites background from "Agency Costs of Free Cash Flow"
...Research grounded in the agency framework highlights the perils of excessive financial slack in the presence of managerial self-interest (Jensen, 1986)....
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TL;DR: Wang et al. as mentioned in this paper used a difference-in-differences (DID) method to quantitatively analyze the impact of carbon emissions' environmental regulation on the stock returns of companies.
137 citations
TL;DR: In this paper, the correlation between the GIS and the Corporate Financial Performance (CFP) with regards to the firm size has been determined for 163 international automotive firms, from the CSRHub database, for the period ranging between 2011 and 2017.
117 citations
Cites background from "Agency Costs of Free Cash Flow"
...…ROE showed a positive correlation with the leverage, which indicated that the debt played a positive role in decreasing the agency issues as it discouraged the free cash flow M AN US CR IP T AC CE PT ED over-investment by the self-serving managers (Jensen, 1986; Stulz, 1990; Harvey et al., 2004)....
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References
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Journal Article•
TL;DR: In this article, the effect of financial structure on market valuations has been investigated and a theory of investment of the firm under conditions of uncertainty has been developed for the cost-of-capital problem.
Abstract: The potential advantages of the market-value approach have long been appreciated; yet analytical results have been meager. What appears to be keeping this line of development from achieving its promise is largely the lack of an adequate theory of the effect of financial structure on market valuations, and of how these effects can be inferred from objective market data. It is with the development of such a theory and of its implications for the cost-of-capital problem that we shall be concerned in this paper. Our procedure will be to develop in Section I the basic theory itself and to give some brief account of its empirical relevance. In Section II we show how the theory can be used to answer the cost-of-capital questions and how it permits us to develop a theory of investment of the firm under conditions of uncertainty. Throughout these sections the approach is essentially a partial-equilibrium one focusing on the firm and "industry". Accordingly, the "prices" of certain income streams will be treated as constant and given from outside the model, just as in the standard Marshallian analysis of the firm and industry the prices of all inputs and of all other products are taken as given. We have chosen to focus at this level rather than on the economy as a whole because it is at firm and the industry that the interests of the various specialists concerned with the cost-of-capital problem come most closely together. Although the emphasis has thus been placed on partial-equilibrium analysis, the results obtained also provide the essential building block for a general equilibrium model which shows how those prices which are here taken as given, are themselves determined. For reasons of space, however, and because the material is of interest in its own right, the presentation of the general equilibrium model which rounds out the analysis must be deferred to a subsequent paper.
15,342 citations
"Agency Costs of Free Cash Flow" refers background in this paper
...Since the seminal work of Modigliani and Miller (1958) several studies have analyzed the role that taxes play in shaping a firm’s debt policy....
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TL;DR: In this article, the authors predict that corporate borrowing is inversely related to the proportion of market value accounted for by real options and rationalize other aspects of corporate borrowing behavior, such as the practice of matching maturities of assets and debt liabilities.
12,521 citations
"Agency Costs of Free Cash Flow" refers background in this paper
...Subsequent papers have analyzed how leverage can help discipline managers by reducing free cash flow (Myers, 1977; Jensen, 1986, 4 Electronic copy available at: https://ssrn.com/abstract=2667761 1989)....
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TL;DR: In this paper, the authors analyze a firm owned by atomistic shareholders who observe neither cash flows nor management's investment decisions and find that management is forced to invest too little when cash flow is low and too much when it is high.
3,687 citations
"Agency Costs of Free Cash Flow" refers background in this paper
...An important mitigant of FCF conflict is debt because it creates a senior claimant on cash flow (Jensen, 1986; Stulz, 1990)....
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Posted Content•
TL;DR: In this article, the authors consider the problem of aligning managers' interests with those of investors and offer agency-cost explanations of dividends, and conclude that "these two lines of inquiry rarely meet." Yet logically any dividend policy should be designed to minimize the sum of capital, agency and taxation costs.
Abstract: The economic literature about dividends usually assumes that managers are perfect agents of investors, and it seeks to determine why these agents pay dividends. Other literature about the firm assumes that managers are imperfect agents and inquires how managers' interests may be aligned with shareholders' interests. These two lines of inquiry rarely meet.' Yet logically any dividend policy (or any other corporate policy) should be designed to minimize the sum of capital, agency, and taxation costs. The purpose of this paper is to ask whether dividends are a method of aligning managers' interests with those of investors. It offers agency-cost explanations of dividends.
3,183 citations