The Perils of Free Cash Flow, Avoidance of Outside Monitoring, and the Exploitation of the Internal Capital Market

47 Pages Posted: 7 Nov 2007 Last revised: 3 May 2012

See all articles by Brandon N. Cline

Brandon N. Cline

Mississippi State University

Jacqueline L. Garner

Georgia Institute of Technology - Scheller College of Business

Adam S. Yore

University of Missouri at Columbia - Department of Finance

Date Written: May 1, 2012

Abstract

While internal capital markets may afford firms a real option to avoid costly outside financing [Matsusaka and Nanda (2002)], we show that they also provide an option to avoid the monitoring that accompanies the raising of capital. Consistent with this view, we find conglomerates which cross-subsidize divisions or engage in value-destroying investment avoid oversight from the external capital markets by refraining from issuing capital or paying dividends. We further show that firms that issue capital while operating inefficient internal capital markets suffer significant negative abnormal SEO announcement returns in excess of other diversified firms conducting SEOs. Evidence likewise indicates that these firms suffer from a free cash flow problem. High coincident levels of free cash flow and investment are responsible for these inefficient capital allocations, the acceptance of value-destroying investments, and overall lower long-run firm value. However, we show that the issuance of capital is associated with additional oversight and those firms issuing capital garner significantly more attention from the analyst community. The additional analyst oversight significantly mitigates the free cash flow problem and is ultimately linked to higher firm value.

Keywords: Corporate Diversification, Internal Capital Market, Free Cash Flow, Firm Size, SFAS 131, Seasoned Equity Offerings

JEL Classification: G31, G32, G34

Suggested Citation

Cline, Brandon N. and Garner, Jacqueline L. and Yore, Adam S., The Perils of Free Cash Flow, Avoidance of Outside Monitoring, and the Exploitation of the Internal Capital Market (May 1, 2012). Available at SSRN: https://ssrn.com/abstract=1027224 or http://dx.doi.org/10.2139/ssrn.1027224

Brandon N. Cline

Mississippi State University ( email )

Mississippi State, MS 39762
United States
662.325.7477 (Phone)
662.325.1977 (Fax)

Jacqueline L. Garner

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

Adam S. Yore (Contact Author)

University of Missouri at Columbia - Department of Finance ( email )

403 Cornell Hall
Columbia, MO 65211
United States
573-884-1446 (Phone)

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