Agency Costs of Free Cash Flow
In a 1986 paper in the American Economic Review, Michael Jensen noted that free cash flows allowed firms' managers to finance projects earning low returns which therefore might not be funded by the equity or bond markets. Examining the US oil industry, which had earned substantial free cash flows in the 1970s and the early 1980s, he wrote that
1984 cash flows of the ten largest oil companies were $48.5 billion, 28 percent of the total cash flows of the top 200 firms in Dun's Business Month survey. Consistent with the agency costs of free cash flow, management did not pay out the excess resources to shareholders. Instead, the industry continued to spend heavily on activity even though average returns were below the cost of capital.
Jensen also noted a negative correlation between exploration announcements and the market valuation of these firms - the opposite effect to research announcements in other industries.
Read more about this topic: Free Cash Flow
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