Impact of free cash flows on investments
CHAPTER 1:
Introduction
1.1 Background
Maintaining suitable amount of liquidity within the firms is fundamental for the smooth operations of firms. Managers have a propensity to hold large percentage of firm assets in the form of cash and cash equivalents in order to reinvest on other physical assets, payments to stockholders and to keep cash inside the firm (Almeida, Campello, & S. Weisbach, 2004). The level of cash a firm maintains is described by its policies regarding capital structure, working capital requirements, cash flow management, dividend payments, investments and asset management
(C.Jensen, 2000) broadly defines free cash flow as cash flow in excess of what is required to fund positive NPV investments. Free cash flow is a sign of agency problems because excess cash may not be returned to shareholders. (J. Brailsford & Yeoh, 2004) When firms have free cash, any acquisitions made by these firms are, by definition, negative net present value.
1.2 Importance of the study
A number of investment studies have demonstrated that cash flow is an effective way to predict investment. There are three primary interpretations of this relationship. The first states that a surge in company cash flow is a good indicator of an increased availability of valuable investment projects.
The second interpretation argues that companies already know about potential investment opportunities, but are prevented from investing because of limited access to external sources of financing. As cash flow improves, companies are able to partake of attractive opportunities that would be otherwise unavailable.
The third, known as the "free cash flow theory," asserts that managers do not behave in a manner consistent with profit maximization, as the first two interpretations suggest. Managers instead use increased cash flow to pursue objectives that have little to do with increasing profits and a great deal to do with making the managers' lives better (such as increasing the size of their company), or easier.
1.3 Purpose
The aim to conduct this study is to find out the impact on investments due to the fluctuation in free cash flows. The study focuses on determining the performance of investments due to free cash flows using financial statement data of Pakistani companies in different sectors using regression analysis. Moreover, the behavior of different factors affects a firm's cash holdings. Several studies e.g. the study by (A. Gentry, Newbold, & T. Whitford, 1990) shows that the greater cash flow permits more investment, but also raises the threshold required to justify investment.
1.4 Beneficiary
Pakistani firms can be efficiently benefited with this research because it is seen that Pakistani firms hold a considerable amount of assets in the form of cash and cash equivalents and the trend is found in all firms' sizes.
1.5 Problem Statement
Managers have a tendency to hold large proportion of firm assets in the form of cash and cash equivalents in order to reinvest on other physical assets, payments to stockholders and to keep cash inside the firm (Almeida, Campello, & S. Weisbach, 2004). The problem related to free cash flow arrived when it was started getting observed that the managers do not go for the benefits of shareholders rather managers hold cash and work for their benefits and prefer the bonuses and internal projects and in turn go for negative NPV projects through the free cash flows.. In this way, managers were started taken care of through the share holders and the thesis can help those share holders do so. The study also focused commonly that in Pakistan the firms which pay low dividends have considerable cash holdings. (Afza & Adnan, 2006).
1.6 Thesis Organization
The study presents the thesis on free cash flows and investments on capital expenditure relationships. In the thesis the background of the study as well as the importance of the study is discussed, also the purpose of the study is clearly showed and whoever will be benefited. Then there is the literature which analyzed the past studies that have focused on the same topic and variables. The variables and the statistical technique used is regression. At last the results are concluded accordingly.
1.7 Summary and Conclusion
Growing free cash flows are commonly due to increased earnings. Companies that experience increasing Free Cash Flows, because of the revenue growth, efficiency enhancements, cost declines, share buy backs, distribution of dividend or elimination of debt, could return the future investors. Therefore the investment considers FCF as a measure of value. But decreasing FCF is a sign of danger ahead. In the unavailability of decent FCF, Firms were unable to maintain the earnings growth. The deficient Free Cash Flows for earnings growth could enforce a firm to increase its debt levels. A bad situation, when a firm without enough Free Cash Flow had no liquidity to stay in business. The objective of this study is to find out the impact on investments due to the fluctuation in cash flows. The study observed that the cash flow increases sales growth and sales growth increases performance of firms.
Chapter 2:
Literature Review
2.1 Introduction
A number of Pakistani firms hold a considerable amount of assets in the form of cash and equivalents and this trend became common across all firm sizes. Moreover, the investment opportunities, free cash flow inconsistencies, liquid assets or debt level affected cash (Afza & Adnan, 2006). The study concluded that the relationship between asset management practices and firm's performance also impacts. The study also focused that the firms which pay low dividends hold considerable cash, in Pakistan.
The study by (Afza & Adnan, 2006) emphasized to determine the level of corporate cash that Pakistani firms hold, across different firm sizes, industries and the behavior of many factors that affect firms' cash holding as per the pecking order and free cash flow theories. The findings of the study suggested that Pakistani firms hold a fair amount of assets in the form of cash and equivalents, and the phenomenon commonly viewed across all firms of any size. However, the cash was found to be significantly affected by investment opportunity set, cash flow magnitude, liquid assets substitutes, debt level and cash flow uncertainty. The regression results indicate that all the variables in the model are significant in defining the cash levels of the firms in Pakistan.
2.2 Theories of Free Cash Flows
2.2.1 Free Cash Flow Theory
Jensen explained the free cash flow theory as an incentive the managers that seek to hoard cash in order to increase the amount of assets under their control and to gain power over the firm investment decisions. With the help of cash holdings, managers don't need to raise external funds, so undertake investment decisions that could negatively impact on shareholders wealth.
According to the study by (Brio, Miguel, & Pindado, 2003) high free cash flow firms sustain a decrease in value when invested, whereas the low free cash flow firms that invest, experience an increase in value.
2.2.2 Pecking Order Theory
According to the Pecking order theory, the firms finance investments firstly by the retained earnings, then with safe debt and risky debt, and finally with equity. When current operational cash flows are sufficient enough to finance new investments, firms repay debt and accumulate cash. When retained earnings are not enough to finance current investments, firms use the accumulated cash holdings and, if needed, issue debt.
2.2.3 Agency Theory
According to the agency theory, managers are the agents for shareholders. The shareholders appoint the responsibility of agent (manager) is to take every decision in good faith and take steps to pursue that decision in order to increase the value of shareholders wealth.
The common agency problem for the free cash flows is company's corporate managers' capability to spend extra cash on valueminimizing projects, rather than to pay out to the shareholders (C.Jensen, 2000). Theory in the study by (H. Brush, Bromiley, & Hendrickx, 2000) suggested that managers prefer sales growth and that the free cash flow allow managers to make poor decisions, no prior study tests the underlying premise that free cash flow lead managers to pursue sales growth with belowpar profitability and in turn whether governance moderates this affect.
2.2.4 Trade off Model
According to the tradeoff model, firms set their optimal level of cash holdings. The firms weigh the marginal costs and marginal benefits of holding cash. The main benefits associated with cash holdings include reduction in the likelihood of financial distress, pursuance of the optimal investment policy even when financial constraints are met, and its contribution to minimize the costs to raise external funds or liquidate existing assets. While marginal cost of holding cash is associated with the opportunity cost of the capital due to the low return on liquid assets. (Afza & Adnan, 2006).
2.2.5 Signaling Theory
Signaling theory is comprised of the supposition that information is not identically accessible to every party at a time, and that dissimilar information or information symmetry is the law. Information asymmetries i.e the un identical information asymmetries end up in very little estimates or a suboptimal investment policy. Signaling theory state that corporate financial decisions are signals sent by the company's managers to investors in order to shake up those asymmetries. These signals become the basis of financial communications policy.
2.2.6 Stake Holder Theory
Stakeholder theory in the study by (C.Jensen, 2000) claim that managers are supposed to take conclusions and according to the interests of stakeholders in a company or firm (including not only financial applicants, but also personnel, workforces, clients, customers, communities, society groups, governmental officers, and under some understandings the environment, terrorists, criminals, blackmailers, and thieves).
To the limit that theory of stakeholder claims that companies should pay attention to all their communities, the argument is unassailable. But taken this far stakeholder theory is completely consistent with value maximization which implies that managers must pay due attention to all constituencies that can affect the firm.
2.2.7 Value Maximization Theory
Value maximization says that managers should make all decisions so as to increase the total long run market value of the firm (C.Jensen, 2000). Total worth is the addition of the amounts of all financial claims on company, which would be comprised of preferred stock, debt, equity and warrants.
2.3 Empirical Evidence
In the study given by (Lamont, 1997), the author observed the relationship of cash flow and investment after the oil price decrease in 1986. The author focused on a small group of corporate units and identified shocks to cash that are not correlated (or at least, not positively correlated) with the return to investment. The author used his own methodology using ex ante data; less than 25 percent of their cash flow came from oil. The tests resemble to the regression analysis tests. The conclusions drawn that the decrease in cash/collateral decrease the investment, if the profitability of investment kept constant/fixed, and moreover the finance costs of all the different parts of the same firm or corporation proved to be interdependent.
In the study given by (C. Vogt, 1994), the author focused on the significance of CF (cash Flows) in the company's investment choice where the author identified that it was because firms that waste free cash flow, or because dealt unnecessary high costs and expenses regarding external financing shaped by asymmetric indirect information and managerial investment of free cash flow. The author concentrated on reasons for the strong relationship between cash flow and capital investment spending. In order to analyze the study, the author used two ideas, one related to free cash flows and other to the pecking order. The equilibrium level of Tobin's Q was used in the study to distinguish between liquidity constraints arising from asymmetric information and managerial overinvestment of free cash flow. The author used a model of company's investment consumed by adopting the data that is timeseries crosssectional in which observation was done in time period that is fixed. The author concluded the result that behavior of free cash flow has more impact on lowdividend firms when are invested in tangible assets but in case of Pecking order, the impact is smaller, lowdividend firms and in firms that make less tangible investments.
The studies of (Almeida, Campello, & S. Weisbach, 2004) reflect the importance or the sensitivity of the cash in cash flows. In this study, the author observed through the firm's demand for liquidity to find out the influence of financial limitations and constraints on corporate business policies and the reasons for the strong relationship between cash flow and capital investment spending. The author did his study on the idea that constrained or firms i.e. firms with limitations should had a constructive cash flow effect or sensitivity of cash, whereas unconstrained firms' or unrestricted cash savings were not supposed to be scientifically associated to cash flows. The studies given by (Almeida, Campello, & S. Weisbach, 2004) present that cash flow sensitivity from a sample of firmyears, for which cash flows are strictly larger than required investment (i.e., firmyears with positive "free cash flow"). The methodology used is Model of Liquidity DemandRegression Model. The conclusions obtained in the study by (Almeida, Campello, & S. Weisbach, 2004) show that the investmentcash flow relationships of lowdebt and olderoperator farms were not significantly affected by farm business cycles while investmentcash flow relationships of highdebt and youngoperator farms were affected strongly by business cycles. Debt level held to be the strongest determinant of credit constraints; asset size and operator age were less important.
In the study by (Jokipii & Vahamma, 2006) the authors examined the performance of an investment strategy based on free cash flows using financial statement data in Finland companies. Authors have considered the investments in the stock market. The methodology that was applied was 3 factor pricing model. After the review on the annual financial statements, the authors identified that the portfolio of largecapitalization companies with positive free cash flows, low free cash flow multiples, and low financial leverage consistently outperforms the market portfolio. The results also indicated that the free cash flow anomaly existed in the Finland markets also.
In the research by (Chen, Wai Ho, Lee, & H.H. Yeo, 2000), the researchers analyzed the firm level analysis of its investment opportunities and free cash flow in order to enlighten the cause and source of the wealth effect of financial freedom of 14 emerging countries. It was found that the market's reaction to liberalization of stock market pronouncements were more favorable for firms with highgrowth as compared to firms lowgrowth, resultantly, a conclusion consistent with the investment opportunities hypothesis. The research also revealed that the companies that have high cash flow, practice lower pronouncement period returns, related with stock market liberalization as compared to firms with low cash flow. The results proved that liberalization of stock market guided to the resourceful distribution of capital. The opportunities in investment as predicted by hypothesis that financial liberalization was found to be more important for the firms with highgrowth as compared the firms with for lowgrowth, as highgrowth firms more likely undertake worthwhile investments with financial liberalization that provide the funds to meet their capital needs. It was concluded by free cash flow that showed financial liberalization less valuable for highcashflow firms than for lowcashflow firms. Due to the decrease in cost of equity, capital coupled with financial liberalization presented motivation for large cash flow firms to connect in too much investment.
The study of (Richardson, 2006) showed the degree of a company's level unnecessary and over investment of FCF, and for that author used an accountingbased framework to measure overinvestment and free cash flow. The outcome of research was found persistent with explanations of agency cost, the excessive or overinvestment was focused in firms with the high levels of free cash flow. The research documented a positive relation between investment expenditure and cash flow. The research basically focused to use accounting information to better measure the determinants of free cash flow and overinvestment, and thereby allow a more powerful test of the agencybased explanation for why firm level investment is related to internally generated cash flows. The methodology used was the regression to estimate the expected level of new investment. The results of that paper suggested overinvestment as a common problem for publicly traded US firms. The majority of the free cash flows retained in the form of financial assets. For each additional dollar of free cash flow the average firm in the sample retains 41 cents as either cash or marketable securities.
The study by (Bruinshoofd, 2003) explained that the free cash can be used for more investments and still take the targeted amount of defensive cash balances into the future. The investment is said to be started more easily by the use of excess cash holdings, it could be expected to rely on free cash flow to a smaller extent, and i.e. firms exhibit a lower ICFS (investmentcash flow sensitivity). This summarized empirical study and the author proposed a model for it. As such, author sympathized with all who are concerned with some of the ad hoc research methodologies and conflicting findings within the financing constraints paradigm and want to stress the importance of analyzing what constitutes a constrained firm (Bruinshoofd, 2003).The corporate cash targets allow to measure how much 'free cash' firms retain as it is the free cash due to which firms become able to commit to new investments without any need of external capital markets. Firms with good amount of free cash are not likely to face financing constraints and vice versa. (Bruinshoofd, 2003) concluded in his study that the connection of the analysis of optimal cash holdings with the analysis of investment, subject to financing constraints can clarify whether constrained firms display stronger ICFS or not.
The study by (H. Brush, Bromiley, & Hendrickx, 2000) explored the agency cost due to sales growth in firms with free cash flow as less profitable than sales growth for firms without free cash flow. Large management stock ownership decreased the impact of free cash flow on performance, and allowed high sales growth. The study concluded that the cash flow increases sales growth, and sales growth increases performance in firms without FCF, firms with low levels of FCF and without strong governance, and Owner managed firms with low levels of FCF.
The study by (Pawlina & Renneboog, 2005) sights the sensitivity of investmentcash flow for a huge sample of firms listed on the London Stock Exchange in the 1990s. The study found that investments are sought to be strongly cash flow sensitive; also a negative relationship between the investmentcash flow sensitivity and corporate efficiency (as defined by the ratio of the firm's Tobin's q and to its optimally achievable (hypothetical) q). The regression was used to analyze the data. The data set contained both crosssectional and timeseries observations that were applied on a panel data methodology, after results were found through descriptive analysis. Lower efficiency in the sample of lowq firms linked with a higher cash flow sensitivity of investment indicated that less efficient firms suffer from higher agency cost of free cash flow.
The analysis by (Jorg, Lorderor, & Roth, 2003) centers on the target that managers inquired in particular into the proportion of firms that claim to maximize shareholder wealth. The criteria managers use when deciding what projects to invest in and to value firms and examine whether firms that evaluate investment projects on an NPV basis also took a discounted cash flow (DCF) approach. Since both methods compute value on the basis of discounted future cash flows, logical consistency require that firms that apply the NPV criterion also rely on a DCF approach. Authors investigated whether firms that claim to maximize shareholder value also use NPV and DCF in their decisions. The reason to expect such a tie is that both NPV and DCF help firms identify the investment projects with the greatest value added for the firm. Both metrics help managers maximize firm value. And since inefficient capital markets the NPV of investments or acquisitions increase to shareholders, a strategy of firmvalue maximization related to a rule of shareholder value maximization. The (Jorg, Lorderor, & Roth, 2003) analysis discussed that whether the firms in which the managers who claimed to maximize shareholder value and used the appropriate valuation metrics also experienced better shareprice performance or not. To measure whether managers add to shareholder value it was established whether shareholders' wealth grow faster over time than would be required to compensate the managers for the risk those shareholders bear and the time value of money. So the methodology used the measure of shareprice performance with the abnormal or excess returns experienced by the stockholders of a particular firm in a given period. The capital asset pricing model (CAPM) is made the theoretical benchmark in that computation. The evidence indicates that managers who claim to continue to shareholder value maximization, more likely to use a discounted cash flow (DCF) firmvaluation approach. Shareholdervalue maximizing managers were not likely than other managers to rely on the net present value (NPV) investment rule. The study focused on whether managers who wanted to maximize shareholder value also achieve greater stockprice performance and vice versa. Overall, (Jorg, Lorderor, & Roth, 2003) found that, managers mention several contradictory goals. In unlisted firms, managers even agree that both shareholder and stakeholder value can be maximized at the same time.
Through free cash flows, i.e., money after cash incomes after taxes, scheduled interest payments, and dividend payouts are done by the firms. The study by (Huang, 2009) illustrated that firms raised their cash assets to formulate for future security investment projects and reserve something for shortages. Firms gather cash if upcoming cash flows stood more unstable and investment opportunities exist as less predictable. Financially and economically constrained companies having poor utilization to credit situate likely to protect cash from the cash flows (Almeida, Campello, & S. Weisbach, 2004).The literature considers the main conflicts amongst the management and shareholders. Well, the interests of shareholders or creditors could diverge and disagreed on the ideal cash holding as well as the capital structure policies. Good corporate governance and policies from the shareholders' perspective were considered harmful for the creditors. With free cash flows borrowers could accumulate cash or repay debts that exist currently.
(Brio, Miguel, & Pindado, 2003) studied a model to analyze the connection between the firm value with investment. That model was estimated by the use of panel data methodology, results were obtained of Spanish firms which focused on the hypotheses that there existed a direct relationship between investment and firm value, but the relation was inversely proportionate to the volume of investment. And value creation over the long run does not depend significantly on whether or not firms announce their investments (divestments). And value creation over the long run said to be dependent on the quality of the investment opportunities. Unusual results were obtained, like the direct, but inversely proportional relationship that exist between a firm's value and the volume of investment, and the fact that positive (negative) market response to investment (divestment) announcements carry on over time. The results demonstrate that the creation of value was greater for those firms with valuable investment opportunities. Secondly for the free cash flow theory, it was found that a decrease in value for firms that invest a high level of free cash flow. With regards to value creation in the long run, the market does not distinguish between firms that announce investment (divestment) and those that invest (divest) but do not announce it. The analysis of the relationship between investment and firm value should also take into account the quality of investment opportunities. The results indicated that the relationship is stronger for firms with valuable investment opportunities.However, that behavior depends on whether firms invest or divest. For the firms that invest, detection for the increase in value which is greater for the firms with valuable investment opportunities, while in the case of firms that divest, market value decrease for the firms with valuable investment opportunities, and increases for the firms without such opportunities. Like, plantclosing announcements made, it bargains that the market response to this kind of divestment depend on the reasons given for the closing, since those announcements may represent good news in several cases. Thus, closing pursuant to a strategic objective labeled as ‘aggressive', and the market expected to react upward. The last discovery was, that the markets responded positively to divestments at the time of the announcement, but those remain followed by a negative reaction.
According to (J. Brailsford & Yeoh, 2004) new investments were considered to be the life of a firm and arose through either capital expenditure or business acquisitions. (J. Brailsford & Yeoh, 2004) dedicated their studies on the market valuation of declaration of new capital expenditure. The company's opportunities for growth and cash flow position are the conditions of the market response; the author observes the part that growth plays and the cash flow, and the relation amongst each other. The sample of Australian firms was used, the outcomes were extraordinarily solid and show a positive relation within the growth opportunities along with the market valuation, in addition to support the parts played by free cash flows. The individual firm factor such as growth could affect the valuation of capital expenditures.
The purpose for the paper given by the author is to study the market response to capital expenditure announcements in the context of the agency problems created by differences in growth and free cash flow environments. A firm that operated in a constrained growth environment was likely to send different signals to the market compared to a firm that operates in a high growth environment. However, growth opportunities themselves must also be examined in light of the firm's available set of free cash flows (C.Jensen, 2000). These results relatively perfect. Author demonstrates that the quality of growth opportunities, especially the most essential variable in explaining the market reaction to physical asset expenditure announcements. Further, the author focused a significant relation between growth and cash flow, thus held the part played by the free cash flows. The results show the interaction between investments, growth, and free cash flow that includes an involvement for valuation signals and managerial investment decision making. This fact is dependable with the definition of the q ratio as an alternate to distinguish between firms that possess positive net present value (NPV) investment opportunities under current management from those that do not results in the positive NPV. Firms with high q ratios are likely to have positive NPV projects. Hence, these firms were expected to invest their resources in profitable projects. For these firms, an increase in new investment was perceived as to have an optimistic outcome on the evaluation of the firm's equity. In contrast, firms with low q ratios face limited growth prospects, and for these firms additional investment was not perceived as generating a positive NPV. Firms lack internally generated cash, and then those firms become dependent on the capital market for funds, also are expected to have greater incentives to make valuemaximizing investment decisions. Otherwise, these managers would be punished by the market through higher borrowing costs or the pause of the supply of funds. Cash flow alone cannot be a sufficient condition for nonvaluemaximizing decisions under the free cash flow argument. The article also examined whether firms with low cash flow experience a greater positive market valuation associated with capital expenditure announcements than firms with high cash flow. The study by (J. Brailsford & Yeoh, 2004) conveyed a definition of capital expenditure, which only included expenditure that remained strictly physical in nature. Such expenditure included expenditure on plant, machinery, property, equipment, and other form of physical asset expenditures, including construction of new plant, installation of new plant, and upgrading of existing plant but excluding assets acquired through mergers and takeovers. The results displayed that growth opportunities became the most important variable to explain the market reaction to physical asset expenditure announcements. Moreover, cash flow itself could not be a relevant variable in the context of growth but, rather, bear a role to interact with growth such that free cash flow became relevant.
The effect of cash flow on capital investment studied with the role that financing constraints play the most attention (Wei & Zhang, 2008). In a perfect market without asymmetric information or financial constraints, a firm's cash flow should not affect its capital investments. Instead, capital investments should be solely determined by the firm's investment opportunities. And in the real market, although firms tend to invest more subsequent increases in their stock prices, cash flow provided to be a better predictor than stock prices of a firm's capital investments. The two competing clarifications were found regarding the direct relation of cash flows with corporate investments. The first explanation based on the costs of agency for FCF as suggested by (C.Jensen, 2000). The free cashflow hypothesis suggested that the direct relation between investments with the cash flows is basically an indication of overinvestment. Firms tend to over invest, not because external capital remains too expensive, but because internal capital stays too inexpensive. The alternative explanation based on asymmetric information. Like the cost of external funds tend to be more expensive than the cost of internal funds due to asymmetric information problems. These asymmetric information hypotheses argue that the direct relation between investment with the cash flows, typically a symptom of underinvestment. Firms mold to keep away from some positive net present value projects because the cost of external capital too high to be compared with the cost of internal capital. Recent studies suggested that since large shareholders gain strong incentives to maximize the value of the stocks, large shareholders could help to overcome this agency problem. However, large shareholders sometime associated with negative entrenchment effects. Authors of the study found that firm valuation initially increased as managerial ownership increased. And after a certain point, firm value started to decrease as managerial ownership increases, because managers become entrenched and start to pursue their private benefits at the expense of outside investors.
The study explored that the investmentcash flow sensitivity decrease with increase in the cashflow rights of the largest shareholders but it increase with the degree of divergence between the cashflow right as well as control rights of the biggest shareholders. All these results exist persistent with the hypothesis of overinvestment originated by the agency costs of free cash flow, but are inconsistent with the underinvestment hypothesis caused by asymmetric information problems.
The research (Rehman & MohdSaleh, 2005) identified 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 coverup the effects of nonwealthmaximizing investments. Results predicted that investors use less earnings and book value information in determining the stock price. In this sense, agency problem caused by FCF, predicted to result a negative influence on decision making. The objectives of the study assess effect of agency problem caused by FCF. Results show that earnings and book value are value relevant and agency problem caused by FCF reduce the worth significance of earnings as well as book value.
(Warusawitharana, 2005) The purchase and sale of operating assets by firms provided a window to study whether managers maximize shareholder value. The paper presented a dynamic, value maximizing model that characterized which firms buy and sell operating assets. The model predicted that highly profitable, large firms would acquire assets from large firms with low profitability. In particular, return on assets and size strongly said to predict which firms buy and sell operating assets. These findings confirmed that shareholder value maximization drive asset acquisitions and sales. The purchase and sale of operating assets by firms provided a light to study whether managers maximize shareholder value. The paper presented a value maximizing model that characterized which firms buy and sell operating assets. The model predicted that highly profitable, large firms acquire assets from large firms with low profitability. Empirical tests using an unexplored data set confirmed the predictions of the model. In particular, return on assets and size strongly predict, which firms buy and sell operating assets. These findings confirmed that shareholder value maximization drive asset acquisitions and sales. Financing constraints also influence the decision of firms to sell assets, as lower levels of liquid assets lead to more asset sales. Though not modeled explicitly, financing constraints can coexist with the value maximizing model. Increased leverage reduces the likelihood of an asset acquisition and increases the likelihood of a sale.
(E. Carpenter, 1994) shed light on results that indicated governance problems associated with the Free Cash Flow model appeared large for several classes of firms. Quantifying governance problems in terms of discount rates presented an opportunity to evaluate the effectiveness of various corporate control mechanisms to decrease the costs of agency for free cash flows.
The studies by (Chen, Wai Ho, Lee, & H.H. Yeo, 2000) examined the responsibility of opportunities opt from investments and free cash flows the foundation of the stock valuation influences of offering the secured debt. In which the author discovered a positive relation in between company's investment with the stock price response to pronouncements of secured debt issues. Helped the hypothesis regarding the investment opportunities that held the debt financing proved more valuable to issue firms with high growth opportunities. Author discovered a deficiency of assistance for the free cash flow hypothesis. These outcomes grip even after control of potentially influential determinants and potential variables. The study provided the awareness of the importance of potential determinants describe the difference in the valuation influence of secured debt issues. Like for R&D expenditures (C. Vogt, 1994), product strategies and capital expenditures (Chen, Wai Ho, Lee, & H.H. Yeo, 2000), but different from that of inter corporate acquisitions which generally supported the free cash flow theory. These conclusions recommended that free cash flow hypothesis may apply to inter corporate acquisitions, but not to strategic investments. The results showed that the free cash flow do not explain the crosssectional differences in abnormal returns associated with the announcements of joint ventures. This is alike for other types of strategic investments such as R&D investments, product strategies and capital expenditures. These findings suggested that, in general, the free cash flow hypothesis may apply to inter corporate acquisitions, but not to strategic investments that also included capital investments. The managers, who plan to abuse the firm's free cash flow on negative NPV projects, may be more likely to do acquisitions than on strategic investments. Another possible reason that the sample firms and those firms that invest in R&D, product strategies and capital expenditures have, on average, better investment opportunities than the bidder firms, and hence, the agency problems of free cash flow might not be as severe.
How does firm investment change with cash flow? (Bertrand & Mullainathan, 2003) examined this question for auctions of oil and gas leases because detailed data on specific investment projects are publicly available in this context. The authors of the study found that as cash flow rise, firms do spend more to purchase a lease. Leases bought when cash flow is high are not more productive are said to be often less productive. These results were most consistent with a free cashflow view of investment in which managers and administrators practice cash flows to make their jobs easier, or it could b said like they want a peaceful and “quiet life” instead of to build an empire. Cash flow often is said to be a better predictor than measure of investment opportunities or other measures of user cost of capital. First, managers choose investments to maximize profits and capital markets that are perfect but cash flow predicted an investment because it is an alternative for future investment opportunities much better than any other measure. Second, managers would like to choose investments to maximize profits but financial constraints and cash flow eased these constraints in order to allow the managers to undertake good projects otherwise would not be able to. Third, managers do not choose investment to maximize profits but rather to acquire private benefits. In this view, managers dissipate free cash on wasteful investment projects because cash on hand is more prone to missspending. This last free cash flow viewed sharply the contrast with the two others to emphasize that high cash flow persuade unprofitable investments. Further controls for Tobin's Q were studied. Thus a positive relationship between capital expenditures and Tobin's Q were found. Investment is positively related to cash flow in the high cash flow range but the relationship less accurately estimated. Only the free cash flow model, where agency problems loom large could total revenues, decrease with cash flow. The results supported free cash flow model in which increased cash flow causes managers to make worse decisions but not to expand their “empires”, referred to as “quiet life” models. The results suggested that corporate governance improved in the oil industry.
(C. Jensen, 2001) argued the Balanced Scorecard, the administrative and managerial equivalent of stakeholders theory. Balanced Scorecard philosophy is inconsistent and showed managers the scorecard which provided no score, even not a singlevalued measure of how results were accomplished. Therefore managers estimated a system to make purposeful decisions. Results found that Balance Score Card could tell managers many interesting things about their business, but it didn't give a score for the organization's performance, or even for the performance of its business units.
Managers are basically enforced by the competitive markets in order to achieve their goals for the maximization of shareholdervalue. (Joerg, Loderer, Roth, & Waelchli, 2007). The market forces do not have any consequence. Competition in markets for all kinds of services or goods pressurized firms to cover costs. The author pointed out that to improve the shareholdervalue is actually an unclear target to be started with—the interests of shortterm and longterm shareholders can be difficult to be brought together. Moreover, shareholder agreement is compromised whenever shareholders have different interests. Many managers are not even willing to state the care for shareholders. This is surprising, because statements that are talked and written seem to be cheap. Yet apparently are not cheap enough. Managers are said not to be willing to publicly endorse shareholdervalue maximization with much enthusiasm. The reluctance to disclose rankings for the various targets those managers claim to pursue, and even when they do, a little evidence that shareholder value kept the top priority. Managers were usually unwilling to hold the shareholder value, so become inconsistent with the claim of a common consensus that the managers should pursue that target. First, it is possible that considerations of political correctness induce managers to misrepresent their preferences, particularly any fondness those managers might have for shareholdervalue maximization. Consistent with that, it is evident that a limited enthusiasm to champion the cause of shareholders is because of internal and external politics. Second, increased share price is not always a policy that shareholders support because of conflicting interests and differed preferences. Shareholder value is an illdefined target which can lack stockholders' consensus. Competitive markets for goods and services tend to force managers to produce efficiently. And competitive capital markets are a threat to job security. Consider the manager's attention for their power and status, the managers would have an motivation to manage the requirements of potential shareholders. A working hypothesis could therefore be that firms operate as if managers maximized their usefulness, subject to the restrictions imposed by competitive markets, large shareholders, and society. Shareholdervalue maximization was found to be least illdefined target. The results showed that it's unclear whether this target brought about the highest social welfare.
Investments applied Tobin's q in the study, to restrict so as to control all the opportunities which were about investment, for a firm. Tobin's q roughly measures the average return on a firm's capital anticipated by the market. More relevant for investment decisions, however, the marginal return on capital (Gugler, C. Mueller, & Yurtoglu, 2004) estimate investment and research and development (R &D) equations using a measure of marginal q. The author used marginal q to identify the existence of cash constraints and managerial discretion and as a separate explanatory variable. For a sample of 560 U.S. firms observed over the 19771996 period the evidence confirmed the existence of both cash constraints in some companies and managerial discretion in others was presented. The hypothesis of AI i.e. asymmetric information for the companies with smart investment opportunities was not able to finance those firms because of insufficient internal cash flows and due to the capital market's unawareness or ignorance of the investment opportunities for the firm, moreover the external funds were too costly in terms of cost. Thus, only firms with large cash flows could finance their attractive investment opportunities, and the relationship among the investment and cash flow is solved. The hypothesis of agency theory related the investment to cash flows by considering that managers acquire financial gains by handling a growing firm and therefore invest without thinking of maximize shareholder wealth. As this happens, a firm's ROI i.e. the (return on investment) reduced than its cost of capital. The result showed that at any point, while some firms under invest because of a shortage of cash, others over invest because of an excess of managerial caution. Any governmental strategies that raise the levels of investment for all companies mitigate the first problem while aggravating the other. The policies which were all about investment and were considered ideal or optimal, targeted the funds to the firms being victim of asymmetric information issues also extracted the funds from the firms with agency issues.
2.4 Summary of Chapter
Different views are in regards to free cash flow. Few authors said that free cash flow was found as a sign of agency problem because excess cash may not be returned to shareholders. Some authors said that the investmentcash flow relationships of lowdebt and olderoperator farms were not significantly affected by farm business cycles while investmentcash flow relationships of highdebt and youngoperator farms were affected strongly by business cycles. Debt level was found to be the strongest determinant of credit constraints; asset size and operator age were less important. Some studies show that firms tend to keep away from some positive net present value projects because the cost of external capital is too high compared with the cost of internal capital. Recent studies suggested that since large shareholders possess strong incentives to maximize the value of the stocks which shareholders own, large shareholders could help to overcome this agency problem. One of the authors suggested that, in general, the free cash flow hypothesis might apply to inter corporate acquisitions, but not to strategic investments that also included capital investments. Some authors found the problem related to free cash flow arrived when it was started getting observed that the managers do not go for the benefits of shareholders rather the managers hold cash and work for their benefits and prefer the bonuses and internal projects and in turn go for negative NPV projects through the free cash flows.
Chapter 3:
Methodology
3.1 Introduction
The data regarding free cash flows and investments are processed in SPSS so as to obtain the relationship of free cash flows on investments and find that how much the independent variable influences the dependent one. The data has been obtained from the public limited companies in Pakistan, from financial statements of the companies.
3.2 Variables used
The variables used are free cash flow and investments. Where free cash flows will be obtained through processing operating income, change in working capital, taxes, interest expenses and depreciation then Investments of the company which will be obtained through sum of the two, research and development expenditure which is net of depreciation and capital expenditure.
3.3 Dependent Variables
In this study, the free cash flow is independent variable and the dependent variable is Investment. An investment is the dependent variable as this is the study of the effect of fluctuations of free cash flows on investments of the organization. Investments are very important factor for success for any organization because of their needs for some times for capital expenditures some times for R&D of the company the company needs investments full fill their requirements.
3.4 Independent variables
Free cash flows is the independent variable the reason of choosing this is that the free cash flow has its effects on firms investments policy and amount of investments the greater the free cash flows the greater the investment opportunities for the firm
3.5 Calculation of dependent and independent variables
The dependent variable investment is calculated by summing capital expenditure and research and development expenditures which should be net of depreciation expenses.
Investments = Capital Expenditure
Independent variable free cash flow is calculated by deducting changes in working capital, tax and interest expenses from operating income and adding back depreciation because of its non cash nature.
Free Cash Flow = Operating Income  Changes in Working Capital  Tax  Interest Expense + Depreciation
(Equity Asset Valuation 2006)
3.6 Data collection
The data is collected from the financial statements of 30 public listed companies of Pakistan which issue relatively high shares. The study analyses the financials statements of those companies for the years 20062008 the financial statements are taken from company's official websites as well as the State Bank Library.
3.7 Sample size
The sample size is 87. The population is all the public limited companies that issue handsome amount of shares. The companies which issue maximum number of shares are the target and have neglected those firms whose data was not published or whose financial statements are not published. The data contains 30 public limited companies and data of 3 years from those 30 companies so therefore 30X3=90 which is the sample size, where whole population is all the public limited companies from Pakistan Stock Exchange.
3.8 Statistical technique used
The study used simple linear regression as the statistical technique as the subject of study is to analyze the impact of free cash flows on investment i.e. one dependent and 1 independent variable is processed. Free cash flows were regressed on investments of the firm. Simple linear regression model (OLS) used to regress on dependent variable on one independent variable.
3.9 Hypothesis
The hypothesis of the study is.
h3. There is a significant positive impact of free cash flows on investments in different companies of Pakistan.
3.10 Summary and conclusions
It is concluded that free cash flows have an impact on the investments because the value of R square is obtained is 31.8% and the adjusted R square is 0.36. More over significance level is .000 which is less than 5% or 0.05. So the model was found significant and the independent variable affects the dependent variable.
Chapter 4:
Results and Interpretations
4.1 Introduction
Quantitative research is used when the data is numeral and when it is necessary to show relationship between variables in quantitative data. Observer used tools, like primary data like questionnaires or such type of equipment to gather the numerical or statistical data. Quantitative or numeric data is comparatively resourceful, also capable to assess the hypotheses through experimental design. The study focuses on determining the achievement of the strategy regarding investment founded on free cash flows using financial statement data of Pakistani companies in different sectors of public limited companies in Pakistan. The data is obtained from the financial statements of the 30 public limited companies that belongs to different sectors in Pakistan and also listed in KSE (Karachi Stock Exchange). Secondary Data was collected and analyzed through statistical tool SPSS using Regression technique
4.2 Interpretations
The model fit output consists of a “Model Summary” which is Table 1and an “ANOVA” which is Table 0. The former includes the multiple correlation coefficients, R, its square, R2, and an adjusted version of this coefficient as summary measures of model fit. The multiple correlation coefficient R = 0.56 indicates that there is a some what strong correlation between the observed investment amounts and those predicted by the regression model. In terms of variability in observed investment amount accounted for by this fitted model, this amounts to a proportion of R2 = 0.318, or 31.8%. By definition R2 will increase when further terms are added.
Table 4.1 Model Summary
Model Summary 

R 
Adj. R2 

1 
.564a 
0.306 
Table 4.2 ANOVA

Sum of Squares 
F 
Sig. 
Regression 
75.281 
27.034 
.000a 
Residual 
161.511 

Total 
236.792 
Table 4.3 Coefficients
Unstandard Coefficients 
Standard Coefficients 
t 
Significance level 

B 
Std. Error 
Beta 

1 
(Constant) 
2.281 
0.867 
2.63 
0.011 

LnFCF 
0.597 
0.115 
0.564 
5.199 
0 
a. Dependent Variable: LnInvestment
Use of this adjusted measure leads to a revised estimate that 30.6% of the variability in investment in the population can be explained by the explanatory variable.
The final row is standard error which is 1.668 which is the difference between the expected and the true values the value of standard error is not much bigger in that case so the model explained that are shows there is lesser differences in expected and actual values.
The ANOVA Table 3 is showing 60 observations which is n1 is 59 as shown in the ANOVA Table observations in the data set the key for ANOVA table is sum of squares for residuals the value of sum of squares is 161.51 in ideal case it should be smaller than sum of squares of regression which is 75.281 here the value is more than that so the less explanatory regression by mean of this if calculate R square by this table sum of square of regression divided by total sum of square which is 75.281/236.792=0.31 which 31% which is also showing that the model is less explanatory.
Now there is F ratio which can be calculated by dividing mean sum of square of residual by mean sum of square of regression which is 75.281/2.785=27.034 F ratio is very significant in testing the hypothesis which is 27.034 which is not much higher value showing the impact of cash flow on investment is not as much higher as expected.
The last value is sig which is 0.000 the value of p which should be less than 0.05 in case of 5% of degree of freedom in this case the model for regression is accepted since p<0.05 so at least investment is depend on cash flows to some extent.
Finally table 3 shows coefficients which provide estimates of the regression coefficients, standard errors of the estimates, ttests that a coefficient takes the value zero, and confidence intervals. The estimated regression coefficients are given under the heading “Unstandardized Coefficients B”; these give, for each of the explanatory variables, the predicted change in the dependent variable when the explanatory variable is improved by a unit conditional on all the other variables in the model remaining constant.
The first column is constant which shows that if cash flows is held to zero the value of investment is 2.281 the second column is slope which is cash flows In this research it is estimated that the investment is 0.597for every increase of 1 unit of cash flows.
The regression coefficient estimate of extroversion has a standard error (heading “Std. Error”) of 0.115 millions and a 95% confidence interval.
Finally, the Coefficients table 4 provides standardized regression coefficients under the heading “Standardized Coefficients Beta”. These coefficients are standardized which shows measure the change in the dependent variable in units of its standard deviation when the explanatory variable increases by one standard deviation. The standardization enables the comparison of effects across explanatory variables. In this research, here increasing cash flows by one standard deviation are estimated to increase investments by 0.564 standard deviations.
The results of ttest which is used to evaluate the differences in means between two groups the positive ttest results shows that there is a variability in dependent variable by cash flows.
The last sig value for all the variables for constant and cash flows are significant for constant it p=0.011 since p<0.05 and for cash flows p=0.00 which is also significant which shows that both variables have impact on investment.
4.4 Log Transformation
In this model log transformation is used. The reason for using logarithmic transformation is it is often used in regression analysis for a variety of purposes such as the linearization of a nonlinear relationship between two or more variables. In this model the same problems occurred of nonlinearization and also the problem of Heteroscedasticity which is (Y for static figures or values of the independent variables don't have any fixed variance. The variances that is Nonconstant in any model of regression, gives the inflated estimates of mean square error. Standard tonics include alterations of the feedback, as well as using a general linear model).
The reason for using log transformation on dependent variable (investment) is that transformation of log for any dependent variable assist to gratify another supposition of linear regression (homoscedasticity).Homoscedasticity is (In regression analysis, the attribute in which distributions having conditions of Y for static values for the independent variable, have the identical variance). Log transformation is also used to addressed the normality issues to make sure set of data is finely modeled through either normal distribution or not, or to compute how much chances a random variable would be normally distributed in this model log transformation is used to correct the normality issues by applying log transformation on dependent and independent variables. By applying log transformation in this model R square has been improved which shows that issues of non linearization is corrected and the model become much significant and also the issues of residual structure is also addressed.
4.5 Conclusion
Linear regression model is used in the study in order to increase normality. The log method is used, where it showed the dependency of the variables that are used in the data of in the sample.
CHAPTER 5
CONCLUSION, DISCUSSIONS, IMPLICATIONS AND FUTURE RESEARCH
5.1 Conclusions
The conclusion shows that the greater free cash flow permits more investment, but also raises the threshold required to justify investment. We also suggested that companies' investments rely on the accessibility of internal funds. The hypothesis that there is a positive relationship of free cash flows on investments is accepted. The results are consistent with the study by (Chen, Wai Ho, Lee, & H.H. Yeo, 2000) which observed the part played by the investment opportunities and free cash flow. These outcomes recommend that the hypothesis of free cash flow might apply to inter corporate acquisitions, but not to strategic investments. The results show that the free cash flow does not explain the differences in abnormal returns associated with the announcements of joint ventures. This is alike for other types of strategic investments such as R&D investments, product strategies and capital expenditures. These findings suggest that, in general, the free cash flow hypothesis may apply to inter corporate acquisitions and to strategic investments that also includes capital investments. The managers who plan to abuse the firm's free cash flow on negative NPV projects may be sometimes likely to do acquisitions than on strategic investments. Another possible reason is that the sample firms and those firms that invest in R&D, product strategies and capital expenditures have, on average, better investment opportunities than the bidder firms, and hence, the agency problems of free cash flow may not be as severe.
5.2 Discussions and Implications
The aim of this study was to sort out the impact on investments due to the fluctuation in free cash flows. 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 are likely to invest in insignificant or even negative NPV project and use income increasing unrestricted increase to camouflage the effects of nonwealthmaximizing investments. As a result, our study predicted that investors will use less earnings and book value information in determining the stock price. In this sense, agency problem caused by FCF is predicted to have a negative influence on the book value for decision making. The main purpose of this thesis is to measure and evaluate the effect of agency problem caused by FCF. As predicted, results show that earnings and book value are value relevant and agency problem caused by FCF reduces the worth significance of earnings as well as book value.
Future Research
The target of the study was to consider two types of investments i.e. capital expenditures and R&D but as the study proceeded, it was clearly observed that the Pakistani Companies are not spending much on R&D so it was considered that only the investments in capital expenditures. Very few companies figured out the importance of R&D and proceeded with this type of investments also. The future study could be made by analyzing the effect of FCFs on stock prices, more over the effect of FCFs on information asymmetries should be examined as well. This study points on capital expenditures and capital expenditure decisions. In future, further investments like Research and Development expenditures will be more creative and come up with a different sample of results. Moreover, this study has not distinguished these forms of announcements of expenditure like R&D expenditures.
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