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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
TL;DR: In this paper, the benefits of debt in reducing agency costs of free cash flows, how debt can substitute for dividends, why diversification programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidationmotivated takeovers, and why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil.
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.
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TL;DR: In this paper, the authors estimate diversification's effect on firm value by imputing stand-alone values for individual business segments and compare the sum of these standalone values to the firm's actual value, and find that overinvestment and cross-subsidization contribute to the value loss.
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TL;DR: In this paper, the authors explore the determinants of liquidation values of assets, particularly focusing on the potential buyers of assets and use this focus on asset buyers to explain variation in debt capacity across industries and over the business cycle.
Abstract: We explore the determinants of liquidation values of assets, particularly focusing on the potential buyers of assets. WVhen a firm in financial distress needs to sell assets, its industry peers are likely to be experiencing problems themselves, leading to asset sales at prices below value in best use. Such illiquidity makes assets cheap in bad times, and so ex ante is a significant private cost of leverage. We use this focus on asset buyers to explain variation in debt capacity across industries and over the business cycle, as well as the rise in U.S. corporate leverage in the 1980s. How DO FIRMS CHOOSE debt levels, and why do firms or even whole industries sometimes change how much debt they have? Why, for example, have American firms increased their leverage in the 1980s (Bernanke and Campbell (1988), Warshawsky (1990)), and why has this debt increase been the greatest in some industries, such as food and timber? Despite substantial progress in research on leverage, these questions remain largely open. In this paper, we explore an approach to debt capacity based on the cost of asset sales. We argue that the focus on asset sales and liquidations helps clarify the crosssectional determinants of leverage, as well as why debt increased in the 1980s. Williamson (1988) stresses the link between debt capacity and the liquidation value of assets. He argues that assets which are redeployable-have alternative uses-also have high liquidation values. For example, commercial land can be used for many different purposes. Such assets are good candidates for debt finance because, if they are managed improperly, the manager will be unable to pay the debt, and then creditors will take the assets away from him and redeploy them. Williamson thus identifies one important determinant of liquidation value and debt capacity, namely, asset redeploya
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