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Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers

01 Jan 1986-The American Economic Review (American Economic Association)-Vol. 76, Iss: 2, pp 323-329

Abstract: The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows—more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why “diversification” programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidationmotivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.
Topics: Operating cash flow (69%), Free cash flow (68%), Cash flow (68%), Cash management (66%), Cash flow forecasting (65%)
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