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Agency Cost Of Free Cash Flow, Corporate Finance, and Takeovers

15 Pages Posted: 25 Mar 1999  

Michael C. Jensen

SSRN; Harvard Business School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit

Abstract

The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows--more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why diversification programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.

Keywords: Dividend policy, Corporate Payout Policy, Optimal Capital Structure, Optimal Debt, Reivestment Policy, Overinvestment

JEL Classification: D23, D24, D82, G31, G34, L21, L22

Suggested Citation

Jensen, Michael C., Agency Cost Of Free Cash Flow, Corporate Finance, and Takeovers. American Economic Review, Vol. 76, No. 2, May 1986. Available at SSRN: https://ssrn.com/abstract=99580 or http://dx.doi.org/10.2139/ssrn.99580

Michael C. Jensen (Contact Author)

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Harvard Business School ( email )

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European Corporate Governance Institute (ECGI) ( email )

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Harvard University - Accounting & Control Unit ( email )

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United States

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