To study and analyze the Agency Cost of Free Cash Flow

1. Agency Costs of Free Cash Flow,
Corporate Finance, and Takeovers
REPORT
Michael C. Jensen 4/30/18 Financial Management Policy
Presented To: Respected Faculty Member Raheel Bhagar
Submitted By: Group K
Members
Danish
&
Syed Muhammad Humza Hussain
Date: August 5, 2018

2. Introduction
ThisStudywill leadusto understand, Corporate Payout Policies, Optimal Debt, Reinvestment Criteria,
DividendPolicyandResultof Overinvestmentinformof Takeover. ThisStudyisconductedbyMichael C.
Jensen.He isan Americaneconomicreview,vol.76,no. 2, papersand proceedings of the ninety-eighth
annual meeting of the American Economic Association. (May, 1986), pp. 323-329. Stable URL:
http://links.jstor.org/sici?sici=0002-8282%28198605%2976%3A2%3C323%3AACOFCF%3E2.0.CO%3B2-M
The American Economic Review is currently published by American Economic Association.
The main content of this study is based on:
1. The role of an agent and his powers to invest.
2. Use Free Cash Flow.
3. Importance debts in order to gain optimal capital structure and to limit agent cost
4. Dividend Policy
5. Causes of takeover
6. Financial restructuring
In everyPublicLimitedcompany the ownersof the businessare separate entity from the business they
hiredpersontodo businessontheirbehalf here the problem of agent begins when you hired a person
to do business he first care about himself and then for the company owners/shareholders so as a
business person he only take risk when it comes with his incentives. An agent is considered to be a
problemwhenthe dividendare reduce ornotprovidedaspercommitmenthe made as dividend one of
the tool that can be deferordelayedasan agentisbetter to save dividend value to further investment
in business regardless the shareholder current expectation when the shareholder wants to break the
corporate monopoly or diplomatic promise the easiest way to put eye on the agent is to take debt
because the debtor will observe each any every project feasibility and put a bars for manager to take
risky projects or to make quasi investments as a finance person the agent always tries to holds is
liabilities as long as he can, and if possible he prefer to defer the same for next period so that the
workingcapital couldbe increase for the current period but this will creases an artificial view of FCF in
the company the debt is the tool which create a barer for agent to cross such limits of deferring the
liabilitiestothatextentthatthe companymay have huge openingdeficitforthe nexttenure because of
itsfix obligation the manger have to performed in a balance way. Free Cash flow is the tool to major a
company,companywithhuge free cashflow gives profitable results you can takeovers in the industry.

3. Literature Review
In thispaper,Jensenhighlightsthe existingconflictbetween shareholder’s and the corporate managers
of a company. Indeed, the payouts of dividend to the shareholders reduce the amount of cash under
managers control which leads to a loss of manager’s power. This is called “Agency Theory”. Jenson is
especially interested in companies with free cash flow (FCF). Managers have incentives to grow their
company,byinvestingthese FCF,intothe companybecause theircompensationislinkedwiththe size of
the company. Besides, This growth policy also facilities the promotions inside the company. Such a
situationimplies thatitisneededtofindsome waystomotivate managerstogive back these FCF to the
investors. The theory develops here describes:
 The benefits of debt in reducing agency costs of free cash flows
 How debt can substitute for dividends
 Why “diversification” program more likely to generate losses than takeovers or expansions in
the same line of the business or liquidation-motivated takeovers
 Why the factors generating takeover activity in such diverse activities as broadcasting and
tobacco are similar to those in oil
 Why bidders and trend to perform abnormally well prior to takeover
1. Accordingto CarolynCarroll & JhonM.Griffi lack positive NPVprojectsandwaste free cashflow
and excessdebtcapacityonbuyingvalue-decreasingtargetsratherthanon payto shareholders.
On the otherhand,hostile bidders generally do not have high free cash flow, and the few that
do apparently do not waste it on buying bad targets.
Explanation:above reference endorsed that the firm that does not have positive NPV opportunities to
investtheirownbusiness,itisbettertopaydividendortobuy back their stock in this study we find out
that the agent has west the FCF by investing it in negative NPV project outside the oil industry.
2. According to J. Service Science & Management, 2010, 3, (408-418) free Cash Flows are the
resources that are under the discretion of management either to invest or not to invest in any
meansas theydeemfit the argumentisthattoo much free cashflow would result in internal in
efficiencyasisitunplannedcashthat needtobe investinanywhere as per management order.
The cost of free cash flow hypothesis states that when the company has generated free cash
flow and there are not positive and profitable investments/ NPV opportunities are available,
management tends to abuse the FCF in hands. By contrast, Lehn and Poulsen [6], Fox and
Marcus [23], and Dial and Murphy [24] suggested the encouraging approach that a firm could
change management’s action in the favor of shareholder by making them partner in the
shareholding of the company so that their interest will be aligned with shareholder as a
shareholder.

4. Explanation:The above reference endorsed that how to increase the interest of a corporate agent and
suggestedasolution to make them partners in shareholding so that their interest will be parallel with
the other shareholders.
3. According to Wikipedia Public companies usually pay dividends on a fixed schedule, but may
declare a dividend at any time, sometimes called a special dividend to distinguish it from the
fixed schedule dividends. Cooperatives, on the other hand, allocate dividends according to
members' activity, so their dividends are often considered to be a pre-tax expense.
Explanation:above reference endorsedthat inthe periodof economicdecline itbetterto pay dividends
to avoidtaxesas dividendpaymentincrease ourexpensesbefore tax unfortunatethe oil industry agents
has invested their FCF in other quasi investment whose NPV is negative resulting losses it’s better to
takeoverothercompanies inthe businessrathertomake false investments.Onthe otherside it’sbetter
to hold dividends in a period of economic growth for further expansion the company.
4. According to Managerial and Decision Economics Vol, 16, 37-46
(1995) managers'effortincentivesare improvedbyhighdebtlevelsonlyunder quite restrictive
conditions.These conditionsare more plausible whenagencyproblemsare due to a managerial
propensityto expand size by investing in negative net present value projects. The results also
imply that when debt is increased to reduce the agency costs of free cash flow, the
accompanying covenants should allow for substantial cash distributions to shareholders even
before bondholder claims are satisfied.
Explanation: above reference endorsed the debt reduces the cost to being made quasi investment by
the agentdue the fact that the chancesof defaultincreasewhenthe investor deem fit that the agent is
wasting the free cash flow in non-productive ideas this sword of being default make the agent
motivatedtokeepaneye of feasibilityof everyprojectinwhichacompanyisgoingto invest,the debt is
alsothe replacementof dividends as if we issue shares we need to sell shares and give dividend but if
we take debt it will only cost interest

5. Conclusion
Firstly,Jensonissupportingthatone of the good wayto reduce these FCFto finance itself indebtedness.
Accordingto Jenson,itismore efficientthandistributing dividends or repurchasing stock. These effect
on the efficiencyof the organizationare calledthe”Control Hypothesis”.Inthiscase, the managers give
the right to the shareholder’srecipientsof the debttotake companyintobankruptcycourt if the debt is
not settled.In this way, debt creation reduces the amount of cash available for spending by managers
and at the same time reducesthe agencycostsof FCF.Furthermore,itisimportant to highlight that this
control Hypothesisdoesnotalwaysimplypositive control effects. Indeed, the control function is more
important in companies that have low growth prospects but that generate high FCF. As a conclusion,
issuingdebtisa promise topayout a certaindividendtothe investor in the future. While promising to
distribute normal dividends can be reversed. This explains how debt can substitute for dividends.
Fee Cashflowisgood when economy isgrowing(boomSituation)if there ishuge space to invest so that
we can use free cash flowtoexpandour companyby investinginitorto gainfrom investingoutside the
industrythe other side is wise versa the free cash flow could be destructive if you have free cash flow
but the economyisdeclining orno positive NPVinvestmentare there sowe shouldbetterpaydividends
or to takeover small fish in the industry with positive NPV and Free Cash flow.
In Pakistancurrentsituationfree cashflow couldbe usedtomake huge profitdue to the ample room in
the oil industrybutwe needtoflowthe optimal capital structure followedinPakistan crude oil industry
to keep the agent motivation high.

6. REFERENCES:
1. Source: Carolyn Carroll & Jhon M.Griffith URL :
http://www.jstor.org/stable/40473338?Search=yes&resultItemClick=true&searchText=use&searchText=of&searchTe
xt=excess&searchText=cash&searchText=and&searchText=debt&searchText=capacity&searchUri=%2Faction%2FdoBa
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a9015de0668997d4594a194f79&seq=1#page_scan_tab_contents
2. Source: J. Service Science & Management, 2010, 3, 408-418 doi: 10.4236/jssm.2010.34047 Published
Online December 2010 (http://www.SciRP.org/journal/jssm)
3. Source: Wikipedia URL: https://en.wikipedia.org/wiki/Dividend
4. Source: Gerald T. Garvey faculty of economics, Australian University, Canberra, Australia:
Managerial and Decision Economics Vol, 16, 37-46
(1995), Debt Finance and the cost of ownership URL:
https://www.jstor.org/stable/2487895?Search=yes&resultItemClick=true&searchText=debt&se
archText=reduce&searchText=agency&searchText=cost&searchUri=%2Faction%2FdoBasicSearc
h%3FQuery%3Ddebt%2Breduce%2Bagency%2Bcost&refreqid=search%3A205970c6005c676ca6
aa4434be2f52ff&seq=1#page_scan_tab_contents.