The Impact of Free Cash Flows and Agency Costs on Firm Performance: Empirical Evidence from KSE 100 Index of Pakistan

Abstract

The agency theory of Jensen and Meckling (1976) and theory of agency cost of free cash flows by Jensen in (1986) states that companies with surplus free cash flows always tend to face conflict of interest between managers and shareholders. This conflict arises due to the separation of ownership and control. Jenson (1987) also put forward the theory of free cash flows (FCF) in which he investigated that agency problem is arises between the shareholder and manager due to FCF. Mangers are agent of the shareholders, and due to the high self-interested parties, there is a serious conflict between them. This paper investigates the impact of free cash flows and agency costs on firm performance and also examines the impact of free cash flow on agency cost. We used the data of financial and non-financial companies listed on Karachi Stock Exchange (KSE 100 index) for the period of 2008 to 2013. Return on asset, return on equity, stock return and Tobin’s used as dependent variables and free cash flows and agency costs as independent variables. Agency costs cannot be measure directly, so we used five proxy variables, total asset turnover, operating cost ratio, administrative and selling expenses ratio, operating income volatility and net income volatility to measure agency cost. Firm size and debt ratio are control variables. We used panel regression model and Hausman (1978) test for the analysis of the data. The results of the study shows that free cash flows have a positive and significant impact on the firm performance. Agency cost has a negative and significant impact on firm performance. Furthermore free cash flows have a significant impact on agency cost. Our results are in favor of agency theory by (Jensen and Meckling, 1976) and free cash flow theory by (Jensen, 1987). The study provides a better understanding of the association among free cash flow, agency cost and firm performance. The study conclude that free cash flows enhance the firm performance but excess free cash flows create the agency problem due to this the conflict of interest increased between owner and management because of such conflict firm performance decrease.