Agency-Costs-of-Free-Cash-Flow-Michael-C.-Jensen

AgencyCostsofFreeCashFlow,CorporateFinance,[e-mail]ndincentivesofmanagersandshareholdersconflictoversuchissuesastheoptimalsizeofthefirmandthepaymentofcashtoshareholders.Theseconflictsareespeciallysevereinfirmswithlargefreecashflows—morecashthanprofitableinvestmentopportunities.Thetheorydevelopedhereexplains1)thebenefitsofdebtinreducingagencycostsoffreecashflows,2)howdebtcansubstitutefordividends,3)why“diversification”programsaremorelikelytogeneratelossesthantakeoversorexpansioninthesamelineofbusinessorliquidation-motivatedtakeovers,4)whythefactorsgeneratingtakeoveractivityinsuchdiverseactivitiesasbroadcastingandtobaccoaresimilartothoseinoil,and5)whybiddersandsometargetstendtoperformabnormallywellpriortotakeover.Keywords:Dividendpolicy,CorporatePayoutPolicy,OptimalCapitalStructure,OptimalDebt,ReivestmentPolicy,Overinvestment©Copyright1986.MichaelC.Jensen.Allrightsreserved.AmericanEconomicReview,May1986,Vol.76,No.2,pp.323-329.Youmayredistributethisdocumentfreely,butpleasedonotposttheelectronicfileontheweb.Iwelcomeweblinkstothisdocumentat=99580.Irevisemypapersregularly,andprovidingalinktotheoriginalensuresthatreaderswillreceivethemostrecentversion.Thankyou,MichaelC.Jensen*LaClaireProfessorofFinanceandBusinessAdministrationandDirectoroftheManagerialEconomicsResearchCenter,UniversityofRochesterGraduateSchoolofManagement,Rochester,NY14627,andProfessorofBusinessAdministration,HarvardBusinessSchool.ThisresearchissupportedbytheDivisionofResearchoftheHarvardBusinessSchool,andtheManagerialResearchCenter,UniversityofRochester.IhavebenefitedfromdiscussionswithGeorgeBaker,GordonDonaldson,AllenJacobs,JayLight,CliffordSmith,WolfWeinhold,andespeciallyArmenAlchianandRichardRuback.AgencyCostsofFreeCashFlow,CorporateFinance,andTakeoversMichaelC.Jensen*AmericanEconomicReview,May1986,Vol.76,No.2,pp.323-329.Corporatemanagersaretheagentsofshareholders,arelationshipfraughtwithconflictinginterests.Agencytheory,theanalysisofsuchconflicts,isnowamajorpartoftheeconomicsliterature.Thepayoutofcashtoshareholderscreatesmajorconflictsthathavereceivedlittleattention.1Payoutstoshareholdersreducetheresourcesundermanagers’control,therebyreducingmanagers’power,andmakingitmorelikelytheywillincurthemonitoringofthecapitalmarketswhichoccurswhenthefirmmustobtainnewcapital(seeEasterbrook,1984,andRozeff,1982).Financingprojectsinternallyavoidsthismonitoringandthepossibilitythefundswillbeunavailableoravailableonlyathighexplicitprices.Managershaveincentivestocausetheirfirmstogrowbeyondtheoptimalsize.Growthincreasesmanagers’powerbyincreasingtheresourcesundertheircontrol.Itisalsoassociatedwithincreasesinmanagers’compensation,becausechangesincompensationarepositivelyrelatedtothegrowthinsales(seeMurphy,1985).The1GordonDonaldson(1984)inhisstudyof12largeFortune500firmsconcludesthemanagersofthesefirmswerenotdrivenbythemaximizationofthevalueofthefirm,butratherbythemaximizationof“corporatewealth,”definedas“theaggregatepurchasingpoweravailabletomanagementforstrategicpurposesduringanygivenplanningperiod”(p.3).“Inpracticaltermsitiscash,credit,andothercorporatepurchasingpowerbywhichmanagementcommandsgoodsandservices”(p.22).MichaelC.Jensen21986tendencyoffirmstorewardmiddlemanagersthroughpromotionratherthanyear-to-yearbonusesalsocreatesastrongorganizationalbiastowardgrowthtosupplythenewpositionsthatsuchpromotion-basedrewardsystemsrequire(seeBaker,1986).Competitionintheproductandfactormarketstendstodrivepricestowardsminimumaveragecostinanactivity.Managersmustthereforemotivatetheirorganizationstoincreaseefficiencytoenhancetheproblemofsurvival.However,productandfactormarketdisciplinaryforcesareoftenweakerinnewactivitiesandactivitiesthatinvolvesubstantialeconomicrentsorquasirents.2Inthesecases,monitoringbythefirm’sinternalcontrolsystemandthemarketforcorporatecontrolaremoreimportant.Activitiesgeneratingsubstantialeconomicrentsorquasirentsarethetypesofactivitiesthatgeneratesubstantialamountsoffreecashflow.Freecashflowiscashflowinexcessofthatrequiredtofundallprojectsthathavepositivenetpresentvalueswhendiscountedattherelevantcostofcapital.Conflictsofinterestbetweenshareholdersandmanagersoverpayoutpoliciesareespeciallyseverewhentheorganizationgeneratessubstantialfreecashflow.Theproblemishowtomotivatemanagerstodisgorgethecashratherthaninvestingitatbelowthecostofcapitalorwastingitonorganizationinefficiencies.Thetheorydevelopedhereexplains1)thebenefitsofdebtinreducingagencycostsoffreecashflows,2)howdebtcansubstitutefordividends,3)why“diversification”programsaremorelikelytogeneratelossesthantakeoversorexpansioninthesamelineofbusinessorliquidation-motivatedtakeovers,4)whythefactorsgeneratingtakeoveractivityinsuchdiverseactivitiesasbroadcastingandtobaccoaresimilartothoseinoil,and5)whybiddersandsometargetstendtoperformabnormallywellpriortotakeover.2Rentsarereturnsinexcessoftheopportunitycostoftheresourcestotheactivity.Quasirentsarereturnsinexcessoftheshort-runopportunitycostofthere