The Impacts of Free Cash Flows and Agency Costs on Firm Performance

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The Impacts of Free Cash Flows and Agency Costs

on Firm Performance

George Yungchih Wang

Department of International Business, National Kaohsiung University of Applied Sciences, Kaohsiung, Taiwan, China. Email:

Received August 6th, 2010; revised October 10th, 2010; accepted November 17th, 2010.


This paper investigates how free cash flow (FCF) is associated with agency costs (AC), and how FCF and AC influence firm performance. The research purpose is therefore threefold. Specifically, the study is to explore the impact of FCF on AC, to re-examine the free cash flow hypothesis, and to test the agency theory based on the empirical data from Taiwan publicly-listed companies. The study uses the variable of standard free cash flow to measure FCF and six proxy variables to measure AC. It is found that FCF has a significant impact on AC with two contrary effects. On one hand, FCF could incur AC due to perquisite consumption and shirking behavior; on the other hand, the generation of FCF, resulting from internal operating efficiency, could lead to better firm performance. Excluding insignificant proxy vari-ables of AC and including only total asset turnover and operating expense ratio as sufficient AC measures, the study finds evidence to support the agency theory, meaning AC has a significantly negative impact on firm performance and stock return. In contrast, the study finds a significantly positive relation between FCF and firm performance measures, indicating lack of evidence supporting the free cash flow hypothesis. The study provides a better understanding of the association among FCF, AC, and firm performance.

Keywords: Agency Theory, Free Cash Flow Hypothesis, Free Cash Flows, Agency Costs, Firm Performance

1. Introduction

The main purpose of business administration and finan- cial management is to pursue perpetual growth of a cor- poration such that the wealth of its stockholders could be maximized. Ever since the disastrous financial tsunami in 2008, corporate financial distresses occurred to several well-known giant enterprises, including Citibank and American International Group (AIG). The U.S. govern- ment thus initiated financial bailout projects in order to save these corporations from financial distress. To our surprise, several companies, after receiving government bailout funding, proposed enormous bonus compensation plans to the management as well as the board of directors. For instance, AIG decided to issue a bonus compensation plan amounted to $165 million dollars to senior man-agement even though the plan had been severely criti-cized by the press. This notorious case presented a di-lemma to government policy-makers whether the gov-ernment should assist these troubled companies out of corporate financial distress [1,2].

Academicians, however, examine the issue in order to find an answer for the dilemma from several different

perspectives. For example, firms are suggested to im-prove their corporate governance and business ethics in order to reduce the self-interest motives of management and to avoid management’s moral hazard, while agency theory examines how management’s behavior could be directed at stockholder’s interest by reducing agency cost. According to Brush, Bromiley, and Hendrickx [3], agen- cy theory holds based on three premises: First, the goal of management is to maximize his/her personal wealth instead of stockholder’s wealth. Second, management’s self-interest motivates waste and inefficiency in the presence of free cash flows (FCF). Third, agency costs are incurred to the burden of stockholders because of weak corporate governance.

The original definition of FCF, according to Jensen [4], is net cash flows of operating cash flows less capital ex-penditure, inventory cost, and dividend payment. The definition is criticized to be lack of accounting precise-ness. Dittmar [5] elaborated on FCF as net cash flows that are at the management’s discretion without affecting corporate operating activities. In the paper, FCF, accord-ing to Lehn and Poulsen [6], is defined as net operataccord-ing


income before depreciation expenses, less tax expenses, interest expenses, and stock dividends, scaled by net sales.

This study, based on the agency theory and the free cash flows hypothesis, aims to explore how free cash flows impact on agency costs and thus on firm perform-ance with the data of Taiwan publicly-listed companies. Free cash flows are the discounted value of all the oper-ating cash flows net of the needs of positive NPV pro-jects. In addition to the accounting concept, free cash flows also represent idle cash flows at the discretion of management. The free cash flows hypothesis, proposed by Jensen [4], states that management could prompt to invest unnecessary, negative NPV projects when there are too much free cash flows in the management’s hands. Furthermore, the hypothesis implies that a higher level of free cash flows would lead t to more of unnecessary ad-ministrative waste and inefficiency.

Specifically, this study is directed to examine the va-lidity of the FCF hypothesis and agency theory, and the linkage between the two theories. The research purpose is therefore three-fold: First, since earlier literature sim-ply regarded FCF as agency costs (see Chung, Firth, and Kim [7,8]) and failed to build up the linkage between FCF and agency costs, the study was intended to fill up the research gap by investigating how the FCFs at man-agement’s discretion would influence agency costs. Sec-ond, since the results of empirical studies on testing the FCF hypothesis were inconsistent, the study would like to empirically test how FCF would impact on firm per-formance by using the data of public-listed companies on Taiwan Stock Exchanges (TWSE). Third, we would also like to re-examine the agency theory by testing how other agency costs would influence firm performance.

The rest of the paper is organized as follows: Section 2 reviews the literature on the free cash flows hypothesis and the agency theory. Section 3 presents the research methodology, the hypotheses, and the testing models. Section 4 presents our statistical results. Section 5 pro-vides concluding remarks.

2. Literature Review

2.1. The Free Cash Flows Hypothesis

Although the first complete study regarding the agency theory was conducted by Jensen and Meckling [9], yet the idea of FCF was originally proposed by Jensen [4], in which FCF is defined as net cash flows after deducting the needs of positive NPV projects. Since FCF is finan-cial resources at the management’s discretion to allocate, it is also called idle cash flows. Jensen [4] argued that too much FCF would result in internal insufficiency and the waste of corporate resources, thus leading to agency

costs as a burden of stockholder’s wealth. Jensen [10] empirically examined the agency problem and thus as-serted that FCF was accused of the main reason why the investment return in the US companies fell below the required rate of return in 1980s.

In additional to FCF, Jensen [10-13] argued that the self-interest motive of management was an important factor leading to agency costs. This was especially obvi-ous when stockholder’s and management’s interests were in conflict, and consequently stockholder’s interest was always dominated by management’s. Brush et al. [3] asserted that weak corporate governance caused the inef-ficiency in the allocation of free cash flows since the corporate board of directors was directed at the policies in favor of management’s interest at the expense of stockholder’s wealth.

The FCF hypothesis states that when a company has generated an excessive surplus of FCF and there are not profitable investment opportunities available, manage-ment tends to abuse the FCF in hands so as to resulting in an increase in agency costs, inefficient resource alloca-tion, and wrongful investment. Brush et al. [3] found that sales growth was most beneficial to companies being lack of cash flows, but not necessarily to companies with sufficient FCF and thus supported the FCF hypothesis. Chung et al. [7] also found that excessive FCF might have a negative impact on corporate profitability and stock valuation and thus suggested the control hypothesis of institutional investors.

Not all empirical evidence supported the FCF hy-pothesis. For instance, Gregory [14] examined how FCF influences merger performance based on the UK data and found that mergers with a higher level of FCF would perform better than those with a lower FCF level as evi-dence invalidating the FCF hypothesis. In addition, the studies conducted by Szewcyzk, Tsetsekos, and Zantout [15] and Chang, Chen, Hsing, and Huang [16] discovered empirical evidence in support of the investment opportu-nity hypothesis that investors would most favor compa-nies with both substantial FCF and profitable investment opportunities in stock valuation.

2.2. Agency Costs

The agency problem was originally raised by Berle and Means [17] who argued that agency costs might be in-curred in the separation of ownership and control due to inconsistent interests of management and stockholders. Jensen and Meckling [9] suggested that the incomplete contractual relationship between the principal (stock-holders) and the agent (management) might cause the agency problem. In general, the agency problem caused by management would cause a loss in stockholders’ wealth in the following ways: First, management, from


the aspect of self-interest motive, would increase perqui-site consumption and shirking behavior, which in turns led to an increase in agency costs. Second, management might not choose the highest NPV investment project, but the one that maximized his own self-interest, which would expose stockholders to unnecessary investment risk. Therefore, management’s decision might cause the firm’s loss in value because the best project was not chosen.

It was obvious that the agency problem caused by management would burden the stockholder’s loss, yet it was not clear how the agency costs were defined as well as measured. Early literature, such as Jensen and Meck-ling [9] and Jensen [4,11,12], argued that there were at least three forms of agency costs: monitoring cost of management’s actions, bonding cost of restrictive cove-nants, and residual loss due to suboptimal management’s decisions. Jensen [4,11,12] linked the agency problem with free cash flows such that management might abuse free cash flows at their authority when investment op-portunities were not readily available to the firm. There-fore, free cash flows to management were agency costs to stockholders.

To tackle the agency problem, two contrasted ap-proaches, the refraining approach and the encouraging approach were suggested. Kester [18] and Gul and Tsui [19] took the refraining approach and argued that an in-crease in financial leverage would sufficiently reduce the agency costs since management is subjective to legal bonding of repaying debt and interest, which in effect might decrease the abuse of free cash flows. In addition, Shleifer and Vishny [20] and Bethel and Liebeskind [21] proposed that corporate takeover could discourage man-agement’s incentive to perquisite consumption and shir- king behavior. Furthermore, Crutchley and Hansen [22] implied that the firm could attempt to distribute idle cash flows to stockholders by stock repurchase or dividend payments to avoid the abuse of free cash flows.

By contrast, Lehn and Poulsen [6], Fox and Marcus [23], and Dial and Murphy [24] suggested the encourag-ing approach that a firm could change management’s action to be more in favor of stockholders by increasing the shares held by management.

Although abundant literature has reviewed the agency theory, yet the measurement of agency costs was still not clearly defined, thus depending on proxy variables. Ac-cording to literature, there were seven proxy variables suggested to measure agency costs: They are total asset turnover [25]; Singh and Davidson [26]), operating ex-pense to sales ratio [25], administrative exex-pense to sales ratio [26], earnings volatility, advertising and R & D ex-pense to sales ratio, floatation cost (Crutchley and

Han-sen [22]), and free cash flows [7,8]. Therefore, the paper also intended to empirically test which proxy variable would better serve as the measurement of agency costs.

3. Research Methodology

3.1. Research Scheme

As mentioned earlier, there were three major research purposes of this study: Firstly, we would like to investi-gate how free cash flows would influence agency costs. Since literature had not identified a proper measure for agency costs, six proxy variables were surveyed for the testing purpose in the presence of agency costs. Secondly, with the empirical data from Taiwan Stock Market, this paper intended to re-examine the free cash flows hy-pothesis, i.e., how FCF would impact firm performance. Thirdly, this paper also intended to empirically examine the linkage between agency costs and firm performance. Therefore, the research scheme was constructed to satisfy the mentioned research purposes, as shown in Figure 1. 3.2. Hypotheses and Models

As shown in Figure 1, four hypotheses were proposed to answer our research questions. In the section, hypotheses and regression models were constructed with the use of ordinary lease square (OLS) method.

3.2.1. Free Cash Flows and Agency Costs

According to Jensen [4,11,12], the free cash flows hy-pothesis stated that as free cash flows became too lavish to the firm, the management tended to increase perquisite consumption and devour more corporate resources, thus causing a loss in firm value. However, the free cash flows hypothesis failed to address how free cash flows would impact on agency costs. Thus, hypothesis 1 was proposed to state the inverse relationship between free cash flows and agency costs.

H1: free cash flows have a positive impact on agency costs.

Since related literature failed to clearly define agency costs, six proxy variables were chosen to test H1. The

Agency Cost Operating Performance Firm Value Stock Return H1 H4 H3 H2

Free Cash Flows


Table 7. The summary table of statistical significance. Statistical Significance Free Cash

Flows Agency Costs

Dependent Variable


AssT OpeR AdmR ARDR NOIVol H1 NIVol ROE + + - + H2 ROA + + - + H3 q + + - + H4 Ri + + - + -

significant effects of free cash flows on agency costs, yet the effects are contrary. On one hand, free cash flows could increase the incentive for management to perqui-site consumption and shirking, thus leading to an in-crease in agency costs. On the other hand, free cash flows are generated due to management’s operating effi-ciency such that there may exist a negative relationship between free cash flows and agency costs. Second, the study finds lack of evidence supporting the free cash flows hypothesis, meaning that free cash flows could render a firm with investment opportunities which would generate more values for the firm. Therefore, free cash flows have a positive impact on firm performance. This finding is consistent with the UK evidence found in Gregory [14]. Third, the proxy variables of agency costs, suggested by literature, are shown to have inconsistent effects on firm performance. It is thus difficult to deter-mine whether there exist a direct linkage between agency costs and firm performance. However, if agency costs are actually, inversely related to firm performance, as sup-ported as in Ang et al. [25] and Singh and Davidson [26], total asset turnover and operating expense ratio could serve as better measures for agency costs.

The study is thus far the first one using Taiwan data to empirically examine the relationship between free cash flows and agency costs, the free cash flows hypothesis, and the agency theory. For future research, it is suggested to direct at examining the industry difference regarding how free cash flows impact on firm performance.


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Figure 1. Research scheme.

Figure 1.

Research scheme. p.3
Table 7. The summary table of statistical significance.

Table 7.

The summary table of statistical significance. p.4