Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers

Jensen, Michael C., 1986, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” The American Economic Review 76 (2), 323-329.

Purpose:  This paper develops a theory linking debt, agency costs of free cash flow, and corporate takeovers.

Theory:  Managers seek to maximize their own influence, and not necessarily shareholder return.  They also have discretion over free cash flow, which represents an agency problem for firms with high free cash flows and low growth prospects.  Debt can be used to limit managers’ discretion over cash flows, and so increases in leverage can create value for shareholders beyond the tax implications.

  • Debt holders can force firm reorganization without bankruptcy more quickly and easily than equity holders.  This means higher-leveraged firms tend to be leaner and better managed.
  • Takeover targets should include firms with poor earnings and poor management, or firms with excellent earnings that management does not use to create value.
  • Lack of growth opportunities frequently leads to the undertaking of value-destroying projects.  Firms pursuing diversification and firms in industries with overcapacity often fit in this category.
  • These firms ought to see more takeovers, threats of takeovers, and subsequent debt increases.

Empirical Evidence:

  • Evidence from LBOs and going-private transactions
    • Most firms that are taken private are those with low growth and high potential for free cash flows—hence, high agency costs.  Strip financing (all bond-holders hold equal proportions of debt in each tier of seniority) reduces conflict of interest among bond holders, which gives them more power over the firm.
    • Very few of these transactions have gone into bankruptcy, suggesting that debt holders can force management efficiency and limit suboptimal investments.
  • Evidence from the oil industry
    • During the 1970s, oil prices increased and optimal capacity decreased, so that oil firms were both highly profitable and destined to shrink.  Oil managers continued investing in exploration & discovery projects that returned less than the cost of capital.
    • Around this time, oil companies began to merge and restructure under threat of takeover.  They increased leverage and cut value-destroying investments.

Conclusions:

  • Managers of firms with low growth opportunities can’t be trusted with high cash flow.
    • Leverage can be used to limit the free cash flow agency problem.
  • Firms with high cash flows and low growth opportunities should be prime takeover targets.
  • Acquisitions financed with debt and cash should create more value than similar transactions done with equity.