Agency Costs of Free Cash Flow
49 Pages Posted: 1 Oct 2015 Last revised: 7 Jul 2016
Date Written: July 1, 2016
Free Cash Flow (FCF) agency conflicts exist when managers divert cash flow for private benefits. We identify the impact of unobservable FCF conflicts on firm policy using a structural approach. Measurement equations are constructed based on observable managerial choices: payout policy changes and personal portfolio decisions around exogenous tax rate changes. We find that FCF agency conflicts cause (i) under-leverage, leading to higher corporate taxes and (ii) under-investment in PP&E, leading to slower firm growth. Capital markets recognize FCF conflicts and discount such firms. Finally, firms with (i) large institutional holdings or (ii) better-aligned executive compensation, suffer less from FCF agency conflicts.
Keywords: Free Cash Flow, Agency Costs, Dividend, Debt, Executive Compensation
JEL Classification: G24, G32, G14
Suggested Citation: Suggested Citation