Free Cash Flow, Optimal Contracting, and Takeovers

Rodney L. White Center Working Paper No. 3-97

Posted: 21 Apr 1997

See all articles by Eitan Goldman

Eitan Goldman

Indiana University - Kelley School of Business - Department of Finance

Christopher S. Jones

University of Southern California - Marshall School of Business - Finance and Business Economics Department

Ron Kaniel

University of Rochester - Simon Business School; CEPR

Date Written: Undated

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

Suggested Citation

Goldman, Eitan and Jones, Christopher S. and Kaniel, Ron, Free Cash Flow, Optimal Contracting, and Takeovers (Undated). Rodney L. White Center Working Paper No. 3-97. Available at SSRN: https://ssrn.com/abstract=8294

Eitan Goldman

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States
812-856-0749 (Phone)

Christopher S. Jones (Contact Author)

University of Southern California - Marshall School of Business - Finance and Business Economics Department ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

Ron Kaniel

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

HOME PAGE: http://rkaniel.simon.rochester.edu

CEPR ( email )

London
United Kingdom

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