A Test of the Free Cash Flow Hypothesis: The Impact of Increased Institutional Holdings on Firm Characteristics

Abstract

This paper tests the free cash flow hypothesis and analyzes the impact of the increased institutional ownership on firm characteristics. Institutional ownership of U.S. equities increases from 7.3% in 1980 to 45.7% in 2009. Greater institutional ownership reduces the agency problem of free cash flow. We find that the increased institutional ownership results in the lower leverage and payout that consequently lead to greater cash holdings and firm value. The results support the free cash flow hypothesis and provide an alternative explanation why firms hold so much cash and why debt and payout ratios decrease during the last 30 years.