High Free Cash Flow Research Articles

Examining auditing fees change from free cash flow viewpoint

This research mainly aimed at examining the relationship between free cash flow and auditing fees. It is required to mention that the mangers of free cash flow do not invest the commercial units in projects with positive NPV based on the theory of contradictory interests of managers and owners. In this research, the companies were divided into two lower and upper classes and model of auditing fees and artificial variable of free cash flow (FCF) and debt ratio of divided interest was used. In order to collect the required data and test the hypotheses, information stipulated in financial statements and notes of 50 companies and market information, Rahavard Novin software, Tadbir Pardaz softer, Sahra softer, stock organization library and stock sites such as www.rdis.ir and www.irbourse.com were used. Accessible extra cash amounts for investment is effective and agency problems of free cash flow damage the value as a result of probable increase in investment. Also, the contradiction of the interests between shareholders and managers may be intensified in companies with high free cash flow and low growth view. Obligations may result in increasing auditors’ attempts, auditing risk and effort, auditing fees, and applying them may raise some questions about management credit. This research provided a good chance for examining the effect of some charges of free cash flow agency regarding auditing wage. Meanwhile, it took into consideration whether other control mechanisms such as debt divided interest have any effect on auditing fees and auditors or not. Key words: Auditing fees, free cash flow, agency problems.

Management Entrenchment, Agency Problem and Audit Fees

This study examines the association between audit fees and management entrenchment, which is proxied by Bebchuk et al. (2005) entrenchment index. The results show that audit fees are significantly positively correlated with Bebchuk et al. (2005) entrenchment index controlling for other factors. Further results show that the positive relation between audit fees and the entrenchment index exists only in firm with low growth opportunity and high free cash flow (i.e. firms with severe Jensen agency problem). These results indicate that firms’ agency problems moderate the association between audit fees and management entrenchment.

DISCUSSION OF Do Debt Constraints Influence Firms' Sensitivity to a Temporary Tax Holiday on Repatriations?

A lbring, Mills, and Newberry (2010) (hereafter, AMN) study the relation between proxies of debt constraints and firms’ responses to the repatriation tax holiday in the American Jobs Creation Act of 2004 (AJCA). Specifically, they investigate whether the existence of a public debt rating and the number of covenants in private debt agreements are associated with the amount of foreign earnings repatriated. Ultimately, AMN find evidence that firms’ repatriations are increasing in the existence of a debt rating and decreasing in the number of private debt covenants. Given the ongoing debate regarding the efficacy of the AJCA, which reduced the maximum tax rate on the repatriations to 5.25 percent, AMN address a research question that will be of interest to academics and policy makers alike.

Life-Cycle Theory and Free Cash Flow Hypothesis: Evidence from Dividend Policy in Thailand

This paper examines dividend policy of Thai listed companies over the period 2002-2008. The results show that larger and more profitable firms with higher free cash flows and retained earnings to equity tend to pay higher dividends. In addition, the evidence indicates that firms with higher growth opportunities, proxied by market-to-book ratio, tend to pay lower dividend payout ratio but higher dividend yield. Collectively, the findings from this paper provide much support for the free cash flow and life-cycle hypotheses. Further, it is found that financial leverage is positively related to dividend payouts, a finding which casts doubt whether Thai firms rely on debt to pay dividends.

Does CEO reputation matter for capital investments?

This paper examines the association between CEO reputation and corporate capital investments. The efficient contracting hypothesis predicts a positive association between CEO reputation and wealth effects of corporate capital investments. In contrast, the rent extraction hypothesis predicts that the wealth effects of capital investments are negatively associated with CEO reputation. We find that the stock market's responses to announcements of capital investments are more favorable for firms with more reputable CEOs. Moreover, CEO reputation mitigates the negative stock price reaction associated with announcements of capital investments by firms with high free cash flow and low growth opportunities. Additional analysis indicates that firms with more reputable CEOs exhibit significantly better post-investment operating performance improvements than those with less reputable CEOs, especially in firms with high free cash flow and low growth opportunities. Collectively, our results suggest that the efficient contracting hypothesis dominates the rent extraction hypothesis in terms of net economic impact of capital investments on the investing firm.

Cash acquirers

PurposeThis paper investigates the Jensen's free cash flow (FCF) hypothesis in the context of UK cash acquisitions. Under this hypothesis, financial slack induces mangers to acquire targets for cash if such behaviour generates either pecuniary or non‐pecuniary rewards for them, giving rise to a potential agency problem around cash takeovers. We argue that the stronger position of shareholders, as opposed to firm managers, in the UK should help in constraining such potential agency problems around such mergers. Compared to the USA, position, this should make the FCF hypothesis less relevant in the UK.Design/methodology/approachThis paper uses short‐run announcement period returns and long‐run calendar‐time returns in testing our hypotheses.FindingsThis paper shows that low leverage and high FCF may be advantageous provided shareholder monitoring is adequate. By analysing both announcement period and long‐term returns, we show that acquirers with high levels of FCF are superior performers, and that any long‐run under‐performance of cash acquirers appears to be associated with low cash resources and low institutional ownership.Research limitations/implicationsInevitably, long‐run returns measurement is contentious, although we present results from alternative models to mitigate this. Limitations are necessarily imposed by the sample size, meaning that multi‐way partitioning of the data is not feasible.Practical implicationsThe practical implications are that the UK regulatory and institutional ownership regime may actually protect the interests of shareholders and mitigate agency problems.Originality/valueAs far as we are aware, this is the first paper to systematically test FCF, leverage and institutional ownership effects in the context of UK cash acquisitions.

Risk to Firm Value for Taiwanese Companies Investing in China: Who Fares Better?

The main purpose of this paper is to study the effect on the stock price that a Taiwanese company may experience when announcing it is engaging in foreign direct investment in China. This study has been able to observe the influence of political risk on the FDI announcement effect during one of the tensest periods in the history of the cross-Strait relationship. We have found an overall significantly negative effect for all companies in Taiwan that announced they were investing directly in China during this risky period. We have further found that companies with higher free cash flow and greater information asymmetry experience worse stock price reactions to such announcements, and that those with low growth opportunities, higher institutional shareholdings, outside directors on the board, or a higher ratio of outside directors experience better stock price reactions to the announcements. Finally, we have found that the FDI announcement effect is better for firms whose board chairman also serves as the CEO or for firms that are family controlled.

Agency problems and audit fees: further tests of the free cash flow hypothesis

AbstractThis study finds that the agency problems of companies with high free cash flow (FCF) and low growth opportunities induce auditors of companies in the US to raise audit fees to compensate for the additional effort. We also find that high FCF companies with high growth prospects have higher audit fees. In both cases, higher debt levels moderate the increased fees, consistent with the role of debt as a monitoring mechanism. Other mechanisms to mitigate the agency costs of FCF such as dividend payout and share repurchase (not studied earlier) do not moderate the higher audit fees.

Do Managers Perform for Perks?

We examine how the managerial consumption of perquisites is determined and whether and how it impacts firm value. On the one hand, if the consumption of perks is a result of agency conflict, then it represents managerial excesses and is value-destroying. On the other hand, when the transaction cost of monetary compensation is high due to information asymmetry, government regulations and media scrutiny, perks can provide incentives for managers to work hard to create shareholder wealth. Using manually-collected data on direct monetary compensation and perks for firms in China, we find that perks are provided when the relative pay between top managers and average employees is low, in firms with high free cash flows, high economic rent and growth. Further, perks are positively associated with firm value, but to a much lesser extent than monetary compensation. Therefore, while perks appear to motivate managers to work hard to create shareholder wealth, they are not as effective as monetary compensation. In addition, the predicted or the “optimal” portion of perks motivates managers better than the unpredicted portion of perks. Finally, the effect of perks in enhancing firm value is more pronounced in firms with high economic rent, high growth and low relative pay between top managers and average employees.

The conditional nature of the value of corporate governance

Agency theory suggests that governance matters more among firms with greater potential agency costs. Rational investors are unlikely to value safeguards against unlikely events. Yet, few studies of the relation between governance and firm value control for investor perceptions of the likelihood of agency conflicts. Shleifer and Vishny [Shleifer, A., Vishny, R.W., 1997. A survey of corporate governance. Journal of Finance 52, 737–783] identify investment-related agency conflicts as the more severe type of agency conflicts in the US. We measure the perceived likelihood of this type of agency conflict using free cash flow (Jensen, M.C., 1986. Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review 76, 323–329). We find that firm value is an increasing function of improved governance quality among firms with high free cash flow. In contrast, governance benefits are lower or insignificant among firms with low free cash flow. We show that not controlling for this conditional relation between governance and firm value could lead to erroneous conclusions that governance and firm value are unrelated.

Bringing It Home: A Study of the Incentives Surrounding the Repatriation of Foreign Earnings Under the American Jobs Creation Act of 2004

ABSTRACTThe American Jobs Creation Act of 2004 (the Act) creates a temporary tax holiday that effectively reduces the U.S. tax rate on repatriations from foreign subsidiaries from 35% to 5.25%. Firms receive the reduced tax rate by electing to take an 85% dividends received deduction on repatriations in 2004 or 2005. This paper investigates the characteristics of firms that repatriate under the Act and how they use the repatriated funds. We find that firms that repatriate under the Act have lower investment opportunities and higher free cash flows than nonrepatriating firms. Further, we find that repatriating firms increase share repurchases during 2005 by approximately $60 billion more than nonrepatriating firms, an amount that cannot be explained by differences in earnings between the two groups of firms. This increase represents about 20% of the $291.6 billion repatriated by our sample firms under the Act.

Agency Problems and Audit Fees: Further Tests of the Free Cash Flow Hypothesis

This study finds that the agency problems of companies with high free cash flow (FCF) and low growth opportunities induce auditors of companies in the United States to raise audit fees to compensate for the additional effort. We also find that high FCF companies with high growth prospects have higher audit fees. In both cases, higher debt levels moderate the increased fees, consistent with the role of debt as a monitoring mechanism. Other mechanisms to mitigate the agency costs of FCF such as dividend payout and share repurchase (not studied earlier) do not moderate the higher audit fees.

Value of outside blockholder activism: Evidence from the switchers

This paper measures the value of shareholder activism focusing on outside blockholders who switch their investment purpose from passive to active but are not likely to engage in control-related activities. Unlike the usual 5% ownership disclosure, a switch does not necessarily involve additional share purchase, and thus provides a cleaner test in effectively ruling out alternative theories such as those related to stock picking skills, private information, or herding. We apply the test to outside blockholders in the Korean market, which experienced a concentrated number of switchers in the first half of 2005 when the government adopted a new disclosure rule. We find that target price reaction is significantly positive around the time of the switch disclosure and this effect is more pronounced when the switcher declares to use a wider scope of activist measures. Following the switch, we also find evidence of increases in dividend payouts for firms targeted by switchers with a wider scope of activism, and those with high free cash flows.

Strategic Competition, Valuation, Costs and Growth Potential: The Example of Global Product Design and Development

We study the performance attributes of an international production form that is designed for success in an increasingly global marketplace‐global product design and development. We find that firms elicit higher returns from their global product development when they compete in strategic complements than when they compete in strategic substitutes. These firms are most likely to compete in strategic complements if they have higher free cash flows, but are most likely to compete in strategic substitutes if they are more dominant in their industry. Importantly, global product development reduces cost largely via variable cost reduction. Moreover, we find that global product development contributes to the firm’s growth potential when pursued in conjunction with high multinationalism, aggressive competitive strategy, and high cost saving.

Public-to-private buy-outs, distress costs and private equity

This article extends previous work by testing the financial distress costs hypothesis in the context of the UK, a contract-based distress resolution system, and by considering the role of private equity firms. Using a hand-collected dataset covering 115 public-to-private buy-outs (PTPs) completed in the period 1998 to 2001 and 115 randomly selected firms that remained public, we find contrasting evidence to that for US PTPs. Consistent with the financial distress costs model, firms going private are more likely to have better asset collateralization, have less debt and be more diversified. However, we also find that UK PTPs are more likely to be younger, experience poor stock market performance and be smaller than firms remaining public. In addition, PTPs did not have lower R&D or higher free cash flows. Our results therefore, indicate that in the UK financial distress costs may not be central to the decision to go private.We also find that private equity providers are more likely to be involved in the process if the firm going private is more diversified, has a higher Q ratio and had been quoted for a shorter period of time and have lower board shareholdings. This suggests that private equity providers are more interested in growth prospects than potential financial distress costs.

The Adoption of Deferred Share Unit Plans for Outside Directors and Shareholder Wealth

ABSTRACTManuscript Type: EmpiricalResearch Question/Issue: We examine the impact of the adoption of deferred share unit (DSU) plans for directors on a firm's stock market value. We also examine the differential response to plan and firm characteristics.Research Findings/Results: The sample comprises all firms within Canada's top 1,000 that adopted DSU plans between 1997 (first one) and 2005. Results show that adopters exhibit positive abnormal returns at the adoption announcements and that these vary in accordance with DSU attributes: Investors reward firms that adopt stricter standards. Findings also indicate a more positive reaction when firms are widely held, have higher levels of related directors, higher free cash flows, and are not cross‐listed in the US.Theoretical/Implications: The paper adds to the scant literature on directors' compensation by examining a recent development in directors' pay; DSU plans having many distinguishing features that set them apart from stock options. Second, it investigates whether investors' reaction varies with DSU attributes. Third, the specificity of the Canadian settings allows an analysis of the reaction to DSU adoption given different ownership structures and stock market listing.Practial Implications: The positive stock market reaction to DSU adoption provides valid economic underpinnings to the current worldwide trend in director compensation toward the cancellation of stock option plans and their substitution by DSU. However, the adoption of DSU plans for directors does not add much value in settings where there is already good monitoring by a large shareholder, by a broader investor base or by the board.

The Effect of Free Cash Flow Agency Problem on the Value Relevance of Earnings and Book Value

Prior research identifies free cash flow (FCF) as one source of agency problems between managers and shareholders. Managers of firms with high FCF and of low growth opportunity tend to invest in marginal or even negative NPV project and use income increasing discretionary accruals to camouflage the effects of non‐wealth‐maximizing investments. Therefore, the objective of this study is to assess the value relevance of earnings and book value and the effect of agency problem caused by FCF, on the value relevance of earnings and book value. As predicted, results show that earnings and book value are value relevant and agency problem caused by FCF, reduces the value relevance of earnings and book value. However, the effect is not stable across sample years Firms with FCF agency problem do not have lower earnings (book value) coefficient than other firms in year 2002 (2004). Investigation into specific event that may have driven the difference in result is subject to further research.

Bringing it Home: A Study of the Incentives Surrounding the Repatriation of Foreign Earnings Under the American Jobs Creation Act of 2004

The American Jobs Creation Act of 2004 (the Act) creates a temporary tax holiday that effectively reduces the U.S. tax rate on repatriations from foreign subsidiaries from 35 percent to 5.25 percent. Firms receive the reduced tax rate by electing to take an 85 percent dividends received deduction on repatriations in 2004 or 2005. This paper investigates the characteristics of firms that repatriate under the Act and how they use the repatriated funds. We find that firms that repatriate under the Act have lower investment opportunities and higher free cash flows than non-repatriating firms. Further, we find that repatriating firms increase share repurchases during 2005 by $55.80 to $60.85 billion more than non-repatriating firms. This increase represents 19.14 to 20.87 percent of the $291.6 billion repatriated under the Act. This paper provides useful information to policy makers about the effect of a temporary tax holiday on firms' investment behavior.

Large Shareholder Entrenchment and Performance: Empirical Evidence from Canada

Abstract: Recent empirical evidence indicates that the largest publicly traded companies throughout the world have concentrated ownership. This is the case in Canada where voting rights are often concentrated in the hands of large shareholders, mostly wealthy families. Such concentrated ownership structures can generate specific agency problems, such as large shareholders expropriating wealth from minority shareholders. These costs are aggravated when large shareholders don't bear the full costs of their decisions because of the presence of mechanisms (dual class voting shares, pyramids) which lead to voting rights being greater than the cash flow rights (separation). We assess the impact of separation on various performance metrics while controlling for situations when the large shareholder has (1) the opportunity to expropriate (high free cash flows in the firm) and (2) the incentive to expropriate (low cash flow rights). We also control for when the large shareholder has the power to expropriate (high voting rights, outright control and insider management) and for the presence of family ownership. The results support our hypotheses and indicate that firm performance is lower when large shareholders have both the incentives and the opportunity to expropriate minority shareholders.

Payout Policy, Agency Conflicts, and Corporate Governance

This paper examines the role of corporate governance for payout policy design from the perspective of pre-commitment. We test the effect of external and internal corporate governance on the design of payout policy and use of pre-commitment, level and structure of cash distributions, and firm dividend and repurchase behavior. We argue that firms use pre-commitment to dividend payments to mitigate the agency conflict due to poor governance. We argue that there is an important distinction between dividends and repurchases from the perspective of pre-commitment. Managers that deviate from the chosen dividend policy incur a cost due to a strong negative market response, which reinforces the pre-commitment role of dividends. On the other hand, the market treats share repurchases as more flexible, irregular payouts made at the manager's discretion, which makes repurchases less effective at mitigating the agency conflict. Therefore, a standalone repurchase policy is not sufficient to mitigate the governance failure, introducing the need for dividend pre-commitment as part of payout policy. Empirically, we find that weak governance is associated with a greater emphasis on dividend pre-commitment in total payout composition. Firms with weak governance are also significantly less likely to use standalone repurchase policies as opposed to a dividends - only or a mixed dividends - repurchases payout policy. Costly dividend pre-commitment presents few benefits to well-governed managers. Instead, they either store excess cash in the firm or distribute it through repurchases. We find that the type of monitoring mechanism is relevant for predicting discretionary payouts. Given the generally strong investor protection level in the US, poorly monitored managers are not immune from firing and they will follow a costly dividend policy. Consistent with the proposed explanation, we find that firms with weak corporate governance on average pay higher dividends. The relation between dividends and governance is stronger for firms with high free cash flow. Managers faced with a high takeover threat (external monitoring) are more likely to repurchase and tend to repurchase more on average. On the other hand, strong internal governance (board, institutional blockholder) allows more accurate following of managerial actions and is associated with fewer cash distributions of any kind, including repurchases.