Free Cash Flow, Optimal Contracting, and Takeovers

Abstract:     
A commonly held view in the financial and economic literature is that "free cash flow is bad" in the sense that, given the opportunity, shareholders would always choose to minimize its existence. This view of the world has motivated economists such as Jensen (1988, 1993) to conclude that takeovers, to the extent that they are driven by an overinvestment problem, are beneficial because they both facilitate ex post divertiture and also pose an ex ante threat on managers who overinvest. In this paper we challenge these widely-held beliefs and show that not only might shareholders optimally choose to allow for the existence of free cash flow in the future, but also that the existence of takeovers may actually exacerbate the problem of overinvestment rather than help resolve it.

JEL Classification: G31, G34

working papers series