Jensen (1986) provided the first inkling to agency theory and his discussions about this topic has brought about many fundamental issues in research literature one of which is the free cash flow hypothesis. Jensen (1986) defined free cash flows as the net cash flows in excess of that required to fund all projects that have positive net present values when discounted at relevant cost of capital. Chen et. al (2011) found free cash flow as an indicator of overinvestment. Theoretically, free cash flows are financial resources which the management has the discretion to allocate, therefore, it is also referred to as idle cash flows. Additionally, Jensen (1986) also argued that presence of large amount of free cash flow has consequences. It would result to internal insufficiency and waste of corporate resources that leads to agency costs as a burden to stockholder’s wealth. As a proof to this, Jensen (1993) conducted an empirical examination of agency problem and required rate of return of US firms in the 1980s. The result of the study provided an assertion that free cash flow is responsible why the investment return of US firm on the 1980s fell to the required rate of return.
The free cash flow theory suggested by Jensen states that more internal cash enables the managers to avoid market controlling. Drobetz et a., (2010) argued that managers do not tend to pay cash like dividends and they are motivated to invest, even when there is no investment with positive net present value. This theory shows how managers are driven to collect funds in order to increase the resources under their control and to obtain the powers of judgment and discernment on firm’s investment decisions. Hence, they act using the firm funds in order to avoid presenting detailed information to the capital market, although it is possible that managers invest in projects that may have negative effects on shareholders’ wealth (Ferreira et al., 2004).
The researches examining the role of free cash flow on the decisions related to the investment activities and financing has been studied extensively in the extant literature. Most these researches have supported Jensen’s theory and have confirmed the agency problems in firm with excessive amount of cash flow.
Earlier researches have been aimed at reducing agency costs problems of free cash flow. Dividends and debt are the most prominent mechanisms in the existing literature to counter the agency problems of free cash flow. Myers (1997), Agrawal and Knoeber (1996), and Yilei (2006) found that an increase in debt can create a mechanism against the agency problem caused by free cash flow. Fleming, Heaney, and McCosker (2005) also echoed this argument and name some benefits related to debt financing usage in controlling and reducing agency costs. Grossman and Hart (1982) and Williams (1987) proposed the argument which states that more financial leverage may exert influence on managers and decrease agency costs via the threat of liquidation, which can cause personal losses to managers’ compensation, esteem, and perquisites. This also creates pressure for managers to produce cash flow to cover payment for interest expense payments (Jensen, 1986).
In terms of dividends, Rojeff (1982) and Easterbrook (1984) states that firms who frequently shells out cash for dividend payments visits capital markets for financing needs more frequently. According to Oded (2008), dividends are just like debt which are more flexible, but once it has been announced, it becomes a commitment to pay stockholders cash on a regular basis. This undertaking reduces the amount of resources under the control of managers and leads them to more monitoring by capital markets. Their study reached out to a conclusion that by paying dividends, firms are compelled to resort to capital markets for excess financing which in turn reduces equity agency costs. Christie and Zimmerman (1991) also found out that dividend payouts are helpful in reducing the free cash flow at the discretion of the managers. The results of their study showed that dividend help check managers and create discipline mechanism without intervention of shareholders.
Free cash flow can also be cause of conflict between agents and principals most especially in dividends payout. Rubin (1990) and Lang et. al (1991) found that managers prefer to use free cash flow remaining after investing in negative NPV projects to continue in such projects rather that payout dividends. Aside from investing in negative NPV projects, free cash flow is also used by managers in unnecessary expenditures aligned with their personal interests. Assets whether tangible or tangible can be purchased using a firm’s name, but its purpose is not aligned in the firm’s operations but that of the manager’s personal use. According to the free cash flow hypothesis, managers may be reluctant to debt financing or payout dividends, as these moves reduce free cash flow in their hands
The free cash flow hypothesis states that internally generated cash in excess of net present value projects allows managers to pursue personal goals which results to amplified agency costs, unproductive resource allocation, and misguided investment decision. Researches have been undertaken to provide support for the free cash flow hypothesis, however, the results in the literature have been mixed.
Brush et. Al (2000), in support to the free cash flow hypothesis, maintained that firms with free cash flow gain less from sales growth than firms without free cash flow. Chung et al (2005a), on the other hand, found out that excessive amount of free cash flow influences corporate profitably and stock valuation adversely, thus, recommended the control hypothesis of institutional investor. Dechow et. al (2008), projected that firm with excessive amount of free cash flow have low future performance. The studies of Rozef (1982), Easterbrook (1984), DeAngelo and DeAngelo (2000), and La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000) also reached conclusions supporting the free cash flow hypothesis. The researches of Titman, Wei, and Xie (2004) and Fairfield, Whisenant, and Yohn (2003).
However, several researches painted a different picture of free cash flow hypothesis. Research of Gregory (2005) using UK data found out that mergers with higher level of free cash flow would perform better than those with lower free cash flow level. Thereby overturning the free cash flow hypothesis. Szewcyk, Tsetsekos and Zantout (1996) Chan, Chen, Hsing and Huang (2007) discovered that investors would most likely favor companies with large amount of free cash flow in stock valuation.