26 Pages Posted: 24 Aug 2010
Date Written: August 24, 2010
Jensen (1986) posits that costly conflicts of interest between managers and shareholders are especially pronounced in companies with substantial amounts of free cash flow. Jensen argues that, all else equal, firms that finance assets with debt will be less prone to this agency problem of overinvestment than other firms. Picchi (1985) and McConnell and Muscarella (1986) provide evidence that investment opportunities in exploration and development were quite limited during the early 1980s. During the same period, cash flows to petroleum producers were large because of high crude oil prices. This research uses data from 1979-1985 for a sample of U.S. oil and gas production and exploration companies to test Jensen’s free cash flow theory. Our evidence indicates that estimated agency costs are inversely related to financial leverage, consistent with the control effects of debt. These results persist across a variety of model specifications and data aggregation methods.
Keywords: Free cash flow, agency costs, oil industry
JEL Classification: Q32, G32, G34
Suggested Citation: Suggested Citation
Byrd, John W., Financial Policies and the Agency Costs of Free Cash Flow: Evidence from the Oil Industry (August 24, 2010). Available at SSRN: https://ssrn.com/abstract=1664654 or http://dx.doi.org/10.2139/ssrn.1664654
By Amir Sufi