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AbstractThispaperexaminestheextentoffirmlevelover-investmentoffreecashflow.Usinganaccounting-basedframeworktomeasureover-investmentandfreecashflow,Ifindevidencethat,consistentwithagencycostexplanations,over-investmentisconcentratedinfirmswiththehighestlevelsoffreecashflow.Furthertestsexaminewhetherfirms’governancestructuresareassociatedwithover-investmentoffreecashflow.Theevidencesuggeststhatcertaingovernancestructures,suchasthepresenceofactivistshareholders,appeartomitigateover-investment.KeywordsFreecashflowÆOver-investmentÆAgencycostsJELClassificationG3ÆM4Thispaperexaminesfirminvestingdecisionsinthepresenceoffreecashflow.Intheory,firmlevelinvestmentshouldnotberelatedtointernallygeneratedcashflows(Modigliani&Miller,1958).However,priorresearchhasdocu-mentedapositiverelationbetweeninvestmentexpenditureandcashflow(e.g.,Hubbard,1998).Therearetwointerpretationsforthispositiverelation.First,thepositiverelationisamanifestationofanagencyproblem,wheremanagersinfirmswithfreecashflowengageinwastefulexpenditure(e.g.,Jensen1986;Stulz1990).Whenmanagers’objectivesdifferfromthoseofshareholders,thepresenceofinternallygeneratedcashflowinexcessofthatrequiredtomaintainexistingassetsinplaceandfinancenewpositiveNPVprojectscreatesthepotentialforthosefundstobesquandered.Second,thepositiverelationreflectscapitalmarketimperfections,wherecostlyexternalS.Richardson(&)WhartonSchool,UniversityofPennsylvania,1314SteinbergHall—DietrichHall,Philadelphia,PA19104-6365,USAe-mail:scottric@wharton.upenn.edu123RevAccStud(2006)11:159–189DOI10.1007/s11142-006-9012-1Over-investmentoffreecashflowScottRichardsonPublishedonline:23June2006SpringerScience+BusinessMedia,LLC2006financingcreatesthepotentialforinternallygeneratedcashflowstoexpandthefeasibleinvestmentopportunityset(e.g.,Fazzari,Hubbard,&Petersen,1988;Hubbard,1998).Thispaperfocusesonutilizingaccountinginformationtobettermeasuretheconstructsoffreecashflowandover-investment,therebyallowingamorepowerfultestoftheagency-basedexplanationforwhyfirmlevelinvestmentisrelatedtointernallygeneratedcashflows.Indoingso,thispaperisthefirsttoofferlargesampleevidenceofover-investmentoffreecashflow.Priorresearch,suchasBlanchard,Lopez-di-Silanes,andVishny(1994),documentexcessiveinvestmentandacquisitionactivityforelevenfirmsthatexperiencealargecashwindfallduetoalegalsettlement,Harford(1999)findsusingasampleof487takeoverbids,thatcash-richfirmsaremorelikelytomakeacquisitionsthatsubsequentlyexperienceabnormaldeclinesinoperatingperformance,andBates(2005)findsforasampleof400subsidiarysalesfrom1990to1998thatfirmswhoretaincashtendtoinvestmore,relativetoindustrypeers.Thispaperextendsthesesmallsamplefindingsbyshowingthatover-investmentoffreecashflowisasystematicphenomenonacrossalltypesofinvestmentexpenditure.Theempiricalanalysisproceedsintwostages.First,thepaperusesanaccounting-basedframeworktomeasurebothfreecashflowandover-invest-ment.Freecashflowisdefinedascashflowbeyondwhatisnecessarytomaintainassetsinplaceandtofinanceexpectednewinvestments.Over-investmentisdefinedasinvestmentexpenditurebeyondthatrequiredtomaintainassetsinplaceandtofinanceexpectednewinvestmentsinpositiveNPVprojects.Tomeasureover-investment,Idecomposetotalinvestmentexpenditureintotwocomponents:(i)requiredinvestmentexpendituretomaintainassetsinplace,and(ii)newinvestmentexpenditure.Ithendecomposenewinvestmentexpenditureintoover-investmentinnegativeNPVprojectsandexpectedinvestmentexpenditure,wherethelattervarieswiththefirm’sgrowthoppor-tunities,financingconstraints,industryaffiliationandotherfactors.Undertheagencycostexplanation,managementhasthepotentialtosquanderfreecashflowonlywhenfreecashflowispositive.Attheotherendofthespectrum,firmswithnegativefreecashflowcanonlysquandercashiftheyareabletoraise‘‘cheap’’capital.Thisislesslikelytooccurbecausethesefirmsneedtobeabletoraisefinancingandtherebyplacethemselvesunderthescrutinyofexternalmarkets(DeAngelo,DeAngelo,&Stulz,2004;Jensen,1986).Consis-tentwiththeagencycostexplanation,Ifindapositiveassociationbetweenover-investmentandfreecashflowforfirmswithpositivefreecashflow.1Forasampleof58,053firm-yearsduringtheperiod1988–2002,Ifindthatforfirmswith1Priorworkinfinanceandeconomicsexaminingtherelationbetweencashflowandinvestmentexpenditurehastendedtouseeitherbalancesheetmeasuresofthestockofcashandcashequivalents(e.g.,Harford,1999)orearningsbasedmeasuresasaproxyforcashflow(e.g.,Lang,Stulz,&Walkling,1991;Opler&Titman,1993).Itiswellknownthatearningsandcashflowsarenotequivalentmeasures(e.g.,Sloan,1996).Thispaperseekstomeasurefreecashflowdirectlyusinginformationfromthestatementofcashflowsasopposedtonoisycombinationsfromtheincomestatementandbalancesheet.160S.Richardson123positivefreecashflowtheaveragefirmover-invests20%ofitsfreecashflow.Furthermore,Idocumentthatthemajorityoffreecashflowisretainedintheformoffinancialassets.Theaveragefirminmysampleretains41%ofitsfreecashflowaseithercashormarketablesecurities.Thereislittleevidencethatfreecashflowisdistributedtoexternaldebtholdersorshareholders.Findinganassociationbetweenover-investmentandfreecashflowiscon-sistentwithrecentresearchdocumentingpoorf