agency cost of free cash flows

7/30/2019 Agency Cost of Free Cash Flows

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American Economic Association

Agency Costs of Free Cash Flow, Corporate Finance, and TakeoversAuthor(s): Michael C. JensenReviewed work(s):Source: The American Economic Review, Vol. 76, No. 2, Papers and Proceedings of the Ninety-Eighth Annual Meeting of the American Economic Association (May, 1986), pp. 323-329Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/1818789 .

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Agency Costs of Free Cash Flow, Corporate Finance,and TakeoversBy MICHAEL C. JENSEN*

Corporate managers are the agents ofshareholders, a relationship fraught withconflicting interests. Agency theory, the anal-ysis of such conflicts, is now a major part ofthe economics literature. The payout of cashto shareholders creates major conflicts thathave received little attention.' Payouts toshareholders reduce the resources undermanagers' control, thereby reducing man-agers' power, and making it more likely theywill incur the monitoring of the capitalmarkets which occurs when the firm mustobtain new capital (see M. Rozeff, 1982;F. H. Easterbrook, 1984). Financing projectsinternally avoids this monitoring and thepossibility the funds will be unavailable oravailable only at high explicit prices.Managers have incentives to cause theirfirms to grow beyond the optimal size.Growth increases managers' power by in-creasing the resources under their control. Itis also associated with increases in managers'compensation, because changes in com-pensation are positively related to the growth

in sales (see Kevin Murphy, 1985). The ten-dency of firms to reward middle managersthrough promotion rather than year-to-yearbonuses also creates a strong organizationalbias toward growth to supply the new posi-tions that such promotion-based reward sys-tems require (see George Baker, 1986).Competition in the product and factormarkets tends to drive prices towards mini-mum average cost in an activity. Managersmust therefore motivate their organizationsto increase efficiency to enhance the prob-ability of survival. However, product andfactor market disciplinary forces are oftenweaker in new activities and activities thatinvolve substantial economic rents or quasirents.2 In these cases, monitoring by thefirm's internal control system and the marketfor corporate control are more important.Activities generating substantial economicrents or quasi rents are the types of activitiesthat generate substantial amounts of freecash flow.Free cash flow is cash flow in excess ofthat required to fund all projects that havepositive net present values when discountedat the relevant cost of capital. Conflicts ofinterest between shareholders and managersover payout policies are especially severewhen the organization generates substantialfree cash flow. The problem is how to moti-vate managers to disgorge the cash ratherthan investing it at below the cost of capitalor wasting it on organization inefficiencies.The theory developed here explains 1) thebenefits of debt in reducing agency costs offree cash flows, 2) how debt can substitute

*LaClare Professor of Finance and Business Admin-istration and Director of the Managerial EconomicsResearch Center, University of Rochester GraduateSchool of Management, Rochester, NY 14627, and Pro-fessor of Business Administration, Harvard BusinessSchool. This research is supported by the Division ofResearch, Harvard Business School, and the ManagerialEconomics Research Center, University of Rochester. Ihave benefited from discussions with George Baker,Gordon Donaldson, Allen Jacobs, Jay Light, CliffordSmith, Wolf Weinhold, and especially Armen Alchianand Richard Ruback.'Gordon Donaldson (1984) in his study of 12 largeFortune 500 firms concludes that managers of thesefirms were not driven by maximization of the value ofthe firm, but rather by the maximization of "corporatewealth," defined as "the aggregate purchasing poweravailable to nmanagenmentor strategicpurposesduring ani'giveniplanning period" (p. 3). "In practical terms it iscash, credit, and other corporate purchasing power bywhich management commands goods and services"(p. 22).

2 Rents are returns in excess of the opportunity costof the resources to the activity. Quasi rents are returnsin excess of the short-run opportunity cost of the re-sources to the activity.323

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324 AEA PAPERS AND PROCEEDINGS MAY 1986

for dividends, 3) why "diversification" pro-grams are more likely to generate losses thantakeovers or expansion in the same line ofbusiness or liquidation-motivated takeovers,4) why the factors generating takeover activ-ity in such diverse activities as broadcastingand tobacco are similar to those in oil, and5) why bidders and some targets tend toperform abnormally well prior to takeover.1. TheRole of Debt in MotivatingOrganizationalfficiency

The agency costs of debt have been widelydiscussed, but the benefits of debt in moti-vating managers and their organizations tobe efficient have been ignored. I call theseeffects the "control hypothesis" for debtcreation.Managers with substantial free cash flowcan increase dividends or repurchase stockand thereby pay out current cash that wouldotherwise be invested in low-return projectsor wasted. This leaves managers with controlover the use of future free cash flows, butthey can promise to pay out future cashflows by announcing a "permanent" increasein the dividend. Such promises are weakbecause dividends can be reduced in thefuture. The fact that capital markets punishdividend cuts with large stock price reduc-tions is consistent with the agency costs offree cash flow.Debt creation, without retention of theproceeds of the issue, enables managers toeffectively bond their promise to pay outfuture cash flows. Thus, debt can be an effec-tive substitute for dividends, something notgenerally recognized in the corporate financeliterature. By issuing debt in exchange forstock, managers are bonding their promise topay out future cash flows in a way thatcannot be accomplished by simple dividendincreases. In doing so, they give share-holder recipients of the debt the right to takethe firm into bankruptcy court if they do notmaintain their promise to make the interestand principle payments. Thus debt reducesthe agency costs of free cash flow by reduc-ing the cash flow available for spending atthe discretion of managers. These control

effects of debt are a potential determinant ofcapital structure.Issuing large amounts of debt to buy backstock also sets up the requiredorganizationalincentives to motivate managers and to helpthem overcome normal organizational resis-tance to retrenchment which the payout offree cash flow often requires. The threatcaused by failure to make debt service pay-ments serves as an effective motivating forceto make such organizations more efficient.Stock repurchase for debt or cash also hastax advantages. (Interest payments are taxdeductible to the corporation, and that partof the repurchase proceeds equal to theseller's tax basis in the stock is not taxed atall.)Increased leverage also has costs. As lever-age increases, the usual agency costs of debtrise, including bankruptcy costs. The optimaldebt-equity''ratio i's the point at which firmvalue is maximized, the point where themarginal costs of debt just offset the margin-al benefits.The control hypothesis does not imply thatdebt issues will always have positive controleffects. For example, these effects will not beas important for rapidly growing organiza-tions with large and highly profitable invest-ment projects but no free cash flow. Suchorganizations will have to go regularly to thefinancial markets to obtain capital. At thesetimes the markets have an opportunity toevaluate the company, its management, andits proposed projects. Investment bankersand analysts play an important role in thismonitoring, and the market's assessment ismade evident by the price investors pay forthe financial claims.

The control function of debt is more im-portant in organizations that generate largecashlows but have low growth prospects,and even more important in organizationsthat must shrink. In these organizations thepressures to waste cash flows by investingthem in uneconomic projects is most serious.II. Evidence romFinancialRestructuring

The free cash flow theory of capital struc-ture helps explain previously puzzling results



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VOL. 76 NO. 2 THE MARKET FOR CORPORATE CONTROL 325

on the effects of financial restructuring. Mypaper with Clifford Smith (1985, Table 2)and Smith (1986, Tables 1 and 3) summarizemore than a dozen studies of stock pricechanges at announcements of transactionswhich change capital structure. Most lever-age-increasing transactions, including stockrepurchases and exchange of debt or pre-ferred for common, debt for preferred, andincome bonds for preferred, result in signifi-cantly positive increases in common stockprices. The 2-day gains range from 21.9 per-cent (debt for common) to 2.2 percent (debtor income bonds for preferred). Most lever-age-reducing transactions, including the saleof common, and exchange of common fordebt or preferred, or preferred for debt, andthe call of convertible bonds or convertiblepreferred forcing conversion into common,result in significant decreases in stock prices.The 2-day losses range from -9.9 percent(common for debt) to -.4 percent (for callof convertible preferred forcing conver-sion to common). Consistent with this, freecash flow theory predicts that, except forfirms with profitable unfunded investmentprojects, prices will rise with unexpected in-creases in payouts to shareholders (or prom-ises to do so), and prices will fall with reduc-tions in payments or new requests for funds(or reductions in promises to make futurepayments).The exceptions to the simple leveragechange rule are targeted repurchases and thesale of debt (of all kinds) and preferredstock. These are associated with abnormalprice declines (some of which are insignifi-cant). The targeted repurchase price dechineseems to be due to the reduced probability oftakeover. The price decline on the sale of,debt and preferred stock is consistent withthe free cash flow theory because these salesbring new cash under the control of man-agers. Moreover, the magnitudes of the valuechanges are positively related to the changein the tightness of the commitment bonding,the payment of future cash flows, for exam-ple, the effects of debt for preferred ex-changes are smaller than the effects of debtfor common exchanges. Tax effects can ex-plain some of these results, but not all, for

example, the price increases on exchange ofpreferred for common, which has no taxeffects.111. Evidence from LeveragedBuyout andGoing Private Transactions

Many of the benefits in going private andleveraged buyout (LBO) transactions seemto be due to the control function of debt.These transactions are creating a new organi-zational form that competes successfully withthe open corporate form because of ad-vantages in controlling the agency costs offree cash flow. In 1984, going private trans-actions totaled $10.8 billion and represented27 percent of all public acquisitions (bynumber, see W. T. Grimm, 1985, Figs. 36and 37). The evidence indicates premiumspaid average over 50 percent.3Desirable leveraged buyout candidates arefrequently firms or divisions of larger firmsthat have stable business histories and sub-stantial free cash flow (i.e., low growth pros-pects and high potential for generating cashflows)-situations where agency costs of freecash flow are likely to be high. The LBOtransactions are frequently financed with highdebt; 10 to 1 ratios of debt to equity are notuncommon. Moreover, the use of stripfinancing and the allocation of equity in thedeals reveal a sensitivity to incentives, con-flicts of interest, and bankruptcy costs.Strip financing, the practice in which riskynonequity securities are held in approxi-mately equal proportions, limits the conflictof interest among such securities' holdersand therefore limits bankruptcy costs. Asomewhat oversimplified example illustratesthe point. Consider two firms identical inevery respect except financing. Firm A isentirely financed with equity, and firm B ishighly leveraged with senior subordinateddebt, convertible debt and preferred as well

3See H. DeAngelo et al. (1984), and L. Lowenstein(1985). Lowenstein also mentions incentive effects ofdebt, but argues tax effects play a major role in explain-ing the value increase.



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326 AEA PAPERS AND PROCEEDINGS MAY 1986

as equity. Suppose firm B securitiesare soldonly in strips, that is, a buyer purchasingXpercent of any security must purchase Xpercentof all securities,andthe securities re"stapled" together so they cannot be sep-arated later. Securityholders of both firmshave identical unleveredclaims on the cashflow distribution, but organizationally hetwo firms are very different. If firm Bmanagers withhold dividends to invest invalue-reducingprojectsor if they are ificom-petent, strip holders have recourse o reme-dial powersnot available o theequityholdersof firm A. Each firm B securityspecifies herights its holder has in the event of defaulton its dividend or coupon payment, for ex-ample, the right to take the firminto bank-ruptcy or to have board representation.Aseach security above the equity goes into de-fault, the strip holder receivesnew rights tointercede in the organization.As a result, itis easier and quicker to replacemanagers nfirm B.Moreover,becauseeverysecurityholder nthe highlyleveredfirm B has the same claimon the firm, there are no conflicts amongsenior andjunior claimantsoverreorganiza-tion of the claims in the event of default; tothe strip holder it is a matter of movingfunds fromone pocketto another.ThusfirmB need never go into bankruptcy, he re-organization can be accomplishedvolun-tarily, quickly, and with less expense anddisruptionthan throughbankruptcy roceed-ings.Strictlyproportionalholdingsof all securi-ties is not desirable,for example,becauseofIRS restrictions that deny tax deductibilityof debt interest in such situationsand limitson bank holdings of equity. However,risk-less seniordebt needn'tbe in the strip,and itis advantageous to have top-levelmanagersand venture capitalists who promote thetransactionshold a larger hareof theequity.Securities commonly subject to strip prac-tices are often called "mezzanine" inancingand include securitieswith prioritysuperiorto common stock yet subordinate o seniordebt.Top-level managers frequently receive15-20 percent of the equity. Venturecapi-

talists and the funds they represent etainthemajor share of the equity.They control theboard of directors and monitor managers.Managers and venture capitalists have astrong interest in making the venture suc-cessful becausetheirequity nterestsare sub-ordinate to other claims. Success requires(among other things) implementation ofchanges to avoid investment in low returnprojects to generate he cash for debt serviceand to increasethe value of equity.Less thana handful of these ventures have ended inbankruptcy, although more have gonethrough privatereorganizations.A thoroughtest of this organizational orm requires hepassageof time and anotherrecession.

IV. Evidence rom heOil IndustryRadicalchanges n the energymarket ince1973 simultaneously generated large in-creases in free cash flow in the petroleumindustry and requireda major shrinkingofthe industry.In this environment he agencycosts of free cash flow were large, and thetakeovermarket has playeda criticalrole inreducingthem.From 1973 to the late 1970's,

crudeoil pricesincreased enfold. Theywereinitially accompanied by increases in ex-pected future oil pricesand an expansionofthe industry.As consumptionof oil fell, ex-pectations of future increasesin oil pricesfell. Real interest rates and explorationanddevelopmentcosts also increased.As a resultthe optimallevel of refiningand distributioncapacity and crude reservesfell in the late1970's and early 1980's, leavingthe industrywith excess capacity.At the same timeprof-its were high. This occurred because theaverage productivityof resources n the in-dustry increasedwhile the marginalproduc-tivity decreased.Thus, contraryto popularbeliefs, the industry had to shrink.In par-ticular, crude oil reserves (the industry'smajor asset) were too high, and cutbacks nexploration and development (E&D) ex-penditureswererequired see my 1986 paper).Price increasesgenerated argecash flowsin the industry.For example,1984 cashflowsof the ten largest oil companieswere $48.5billion, 28 percentof the total cash flows of



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VOL. 76 NO. 2 THE MARKETFOR CORPORATE CONTROL 327

the top 200 firms in Dun's Business Monthsurvey. Consistent with the agency costs offree cash flow, management did not pay outthe excess resources to shareholders.Instead,the industry continued to spend heavily onE&D activity even though average returnswere below the cost of capital.Oil industry managers also launched di-versification programs to invest funds out-side the industry. The programs involvedpurchases of companies in retailing (Marcorby Mobil), manufacturing (Reliance Electricby Exxon), office equipment (Vydec by Ex-xon), and mining (Kennecott by Sohio,Anaconda Minerals by Arco, Cyprus Minesby Amoco). These acquisitions turned out tobe among the least successful of the lastdecade, partly because of bad luck (for ex-ample, the collapse of the minerals industry)and partly because of a lack of managerialexpertise outside the oil industry. Althoughacquiring firm shareholders lost on theseacquisitions, the purchases generated socialbenefits to the extent they diverted cash toshareholders (albeit to target shareholders)that otherwise would have been wasted onunprofitable real investment projects.Two studies indicate that oil industryexploration and development expenditureshave been too high since the late 1970's.John McConnell and Chris Muscarella(1986)find that announcements of increases in E&Dexpenditures by oil companies in the period1975-81 were associated with systematicdecreases in the announcing firm's stockprice, and vice versa. These results are strik-ing in comparison with their evidence thatthe opposite market reaction occurs tochanges in investment expenditures byindustrial firms, and similar SEC evidence onincreases in R&D expenditures. (See Officeof the Chief Economist, SEC, 1985.) B. Pic-chi's study of returns on E&D expendituresfor 30 large oil firms indicates on average theindustry did not earn "... even a 10% returnon its pretax outlays" (1985, p. 5) in theperiod 1982-84. Estimates of the averageratio of the present value of future net cashflows of discoveries, extensions, andenhanced recovery to E&D expenditures forthe industry ranged from less than 60 to 90

cents on every dollar invested in these activi-ties.V. Takeoversn theOil Industry

Retrenchment requires cdncellation or de-lay of many ongoing and planned projects.This threatens the careers of the peopleinvolved, and the resulting resistance meanssuch changes frequently do not get made inthe absence of a crisis. Takeover attemptscan generate crises that bring about actionwhere none would otherwise occur.Partly as a result of Mesa Petroleum'sefforts to extend the use of royalty trustswhich reduce taxes and pass cash flows di-rectly through to shareholders, firms in theoil industry were led to merge, and in themerging process they incurredlarge increasesin debt, paid out large amounts of capital toshareholders, reduced excess expenditures onE&D and reduced excess capacity in refiningand distribution. The result has been largegains in efficiency and in value. Total gainsto shareholders in the Gulf/Chevron,Getty/Texaco, and Dupont/Conoco mer-gers, for example, were over $17 billion. Moreis possible. Allen Jacobs(1986) estimates totalpotential gains of about $200 billion fromeliminating inefficiencies in 98 firms withsignificant oil reserves as of December 1984.Actual takeover is not necessary to inducethe required retrenchment and return of re-sources to shareholders. The restructuringofPhillips and Unocal (brought about by threatof takeover) and the voluntary Arco restruc-turing resulted in stockholder gains rangingfrom 20 to 35 percent of market value (total-ing $6.6 billion). The restructuring involvedrepurchase of from 25 to 53 percent of equity(for over $4 billion in each case), substan-tially increased cash dividends, sales of as-sets, and major cutbacks in capital spending(including E&D expenditures). Diamond-Shamrock's reorganization is further supportfor the theory because its market value fell 2percent on the announcement day. Its re-structuring involved, among other things, re-ducing cash dividends by 43 percent, re-purchasing 6 percent of its shares for $200million, selling 12 percent of a newly created



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328 AEA PAPERS AND PROCEEDINGS MAY 1986master limited partnership to the public, andincreasing expenditures on oil and gas ex-ploration by $100 million/year.

VI. Free CashFlowTheoryof TakeoversFree cash flow is only one of approxi-mately a dozen theories to explain takeovers,all of which I believe are of some relevance(see my 1986 paper). Here I sketch out someempirical predictions of the free cash flowtheory, and what I believe are the facts thatlend it credence.The positive market response to debt crea-tion in oil industry takeovers (as well as

elsewhere, see Robert Bruner, 1985) is con-sistent with the notion that additional debtincreases efficiency by forcing organizationswith large cash flows but few high-returninvestment projects to disgorge cash to inves-tors. The debt helps prevent such firms fromwasting resources on low-return projects.Free cash flow theory predicts whichmergers and takeovers are more likely todestroy, rather than to create, value; it showshow takeovers are both evidence of the con-flicts of interest between shareholders andmanagers, and a solution to the problem.Acquisitions are one way managers spendcash instead of paying it out to shareholders.Therefore, the theory implies managers offirms with unused borrowingpower and largefree cash flows are more likely to undertakelow-benefit or even value-destroyingmergers.Diversification programs generally fit thiscategory, and the theory predicts they willgenerate lower total gains. The major benefitof such transactions may be that they involveless waste of resources than if the funds hadbeen internally invested in unprofitable pro-jects. Acquisitions not made with stock in-volve payout of resources to (target) share-holders and this can create net benefits evenif the merger generates operating inefficien-cies. Such low-return mergersare more likelyin industries with large cash flows whoseeconomics dictate that exit occur. In declin-ing industries, mergers within the industrywill create value, and mergers outside theindustry are more likely to be low- or evennegative-return projects. Oil fits this descrip-

tion and so does tobacco. Tobacco firms facedeclining demand due to changing smokinghabits but generate large free cash flow andhave been involved in major acquisitions re-cently. Forest products is another industrywith excess capacity. Food industry mergersalso appear to reflect the expenditure of freecash flow. The industry apparently generateslarge cash flows with few growth opportuni-ties. It is therefore a good candidate forleveraged buyouts and these are now occur-ring. The $6.3 billion Beatrice LBO is thelargest ever. The broadcasting industry gen-erates rents in the form of large cash flowson its licenses and also fits the theory. Regu-lation limits the supply of licenses and thenumber owned by a single entity. Thus, pro-fitable internal investments are limited andthe industry's free cash flow has been spenton organizational inefficiencies and diversifi-cation programs-making these firms take-over targets. CBS's debt for stock restructur-ing fits the theory.The theory predicts value increasing take-overs occur in response to breakdowns ofinternal control processes in firms with sub-stantial free cash flow and organizationalpolicies (including diversification programs)that are wasting resources. It predicts hostiletakeovers, large increases in leverage, dis-mantlement of empires with few economiesof scale or scope to give them economicpurpose (for example, conglomerates), andmuch controversy as currentmanagersobjectto loss of their jobs or the changes in organi-zational policies forced on them by threat oftakeover.The debt created in a hostile takeover (ortakeover defense) of a firm suffering severeagency costs of free cash flow is often notpermanent. In these situations, levering thefirm so highly that it cannot continue to existin its old form generates benefits. It createsthe crisis to motivate cuts in expansion pro-grams and the sale of those divisions whichare more valuable outside the firm. The pro-ceeds are used to reduce debt to a morenormal or permanent level. This process re-sults in a complete rethinking of the organi-zation's strategy and its structure.When suc-cessful a much leaner and competitive



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VOL. 76 NO. 2 THE MARKET FOR CORPORATE CONTROL 329organization results.Consistent with the data, free cash flowtheory predicts that many acquirerswill tendto have exceptionally good performancepriorto acquisition. (Again, the oil industry fitswell.) That exceptional performance gener-ates the free cash flow for the acquisition.Targets will be of two kinds: firms with poormanagement that have done poorly prior tothe merger, and firms that have done excep-tionally well and have large free cash flowwhich they refuse to pay out to shareholders.Both kinds of targets seem to exist, but morecareful analysis is desirable (see D. Mueller,1980).The theory predicts that takeoversfinancedwith cash and debt will generate larger ben-efits than those accomplished through ex-change of stock. Stock acquisitions tend tobe different from debt or cash acquisitionsand more likely to be associated with growthopportunities and a shortage of free cashflow; but that is a topic for future consider-ation.The agency cost of free cash flow is con-sistent with a wide range of data for whichthere has been no consistent explanation. Ihave found no data which is inconsistentwith the theory, but it is rich in predictionswhich are yet to be tested.

REFERENCESBaker, George, "Compensation and Hier-archies," Harvard Business School, Jan-uary 1986.Bruner, Robert F., "The Use of Excess Cashand Debt Capacity as a Motive forMerger,"Colgate Darden Graduate Schoolof Business, December 1985.DeAngelo,H., DeAngelo,L.andRice,E.,"GoingPrivate: Minority Freezeouts and Stock-holder Wealth," Journal of Law and Eco-nomics, October 1984, 27, 367-401.Donaldson, Gordon, Managing CorporateWealth, New York: Praeger, 1984.Easterbrook,F. H., "Two Agency-Cost Ex-

planations of Dividends," American Eco-nomicReview, September1984, 74, 650-59.Grimm,W. T., MergerstatReview, 1985.Jacobs,E. Allen,"The Agency Cost of Corpo-rate Control," MIT, February 6, 1986.Jensen, Michael C., "The Takeover Con-troversy: Analysis and Evidence," Man-agerial Economics Research Center,Working Paper No. 86-01, University ofRochester, March 1986.

,_ "When Unocal Won Over Pickens,Shareholders and Society Lost," Financier,November 1985, 9, 50-52._ and Smith, C. W., Jr., "Stockholder,Manager and Creditor Interests: Applica-tions of Agency Theory," in E. Altmanand M. Subrahmanyam, eds., Recent Ad-vances in CorporateFinance, Homewood:Richard Irwin, 1985, 93-131.Lowenstein,L., "Management Buyouts," Co-lumbiaLaw Review, May 1985, 85, 730-84.McConnell, Joh-nJ. and Muscarella,Chris J.,"Corporate Capital Expenditure Decisionsand the Market Value of the Firm," Jour-nal of Financial Economics, forthcoming1986.Mueller, D., The Determinantsand Effects ofMergers, Cambridge: Oelgeschlager, 1980.Murphy, Kevin J., "Corporate Performanceand Managerial Remuneration: An Em-pirical Analysis," Journal of Accountingand Economics, April 1985, 7, 11-42.Picchi, B., "Structure of the U.S. Oil In-dustry: Past and Future," Salomon Broth-ers, July 1985.Rozeff, M., "Growth, Beta and Agency Costsas Determinants of Dividend Payout Ra-tios," Journal of Financial Research, Fall1982, 5, 249-59.Smith, CliffordW., "Investment Banking andthe Capital Acquisition Process," Journalof Financial Economics, Nos. 1-2, 15,forthcoming, 1986.Dun's BusinessMonth, "Cash Flow: The Top200," July 1985, 44-50.Office of the Chief Economist,SEC, "Institu-tional Ownership, Tender Offers, andLong-Term Investments," April 1985.

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