Profit Versus the Free Cash Flow Hypothesis
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Published: Fri, 16 Mar 2018
Free cash flow is the amount of cash that a company has on hand after it has paid all of its expenses, together with investments. Free cash flow is crucial since it permits a company to chase opportunities that enhance shareholder value. Exclusive of cash, it is hard-hitting for the company to build up new goods, make acquisition, pay dividend and reduce debt.
Negative free cash flow is not inevitably a sign of a bad company, although many young companies put a lot of their cash into investments, which diminishes their free cash flow. In other conditions a business is spending so much cash, it should have a good basis for doing so and it should be earning an adequately high rate of return on its investments. Despite the fact that free cash flow does not receive as a lot of media coverage as earnings do, it is measured by some experts to be a better indicator of a company’s financial position.
Michael C. Jensen 1986 in his theory states that free cash flow is additional cash flow that required funding all projects that have positive net present values when discounted at the same or related cost of capital. Conflict of interest between share holders and manager over payout policies are particularly severe when the organization generates large free cash flows.
Jensen (1986) free cash flow theory assumes that operating performance changes are negatively related to the amount of free cash flow, and the association is stronger for buyers with less growth opportunities.
Free Cash Flow According To Investopedia
Some researchers believe that Wall Street focus myopically on earnings where as ignoring the “actual” cash that a firm makes. Earnings can often be steamed up by accounting tricks, but it is tougher to have fake cash flow. For this reason, some investors believe that free cash flow gives a much apparent inspection of the ability to produce cash (hence profits).
Free cash flow statement of some business may considerably different from its cash flow statement. The cash flow statement usually represents, depreciation, earnings before interest, taxes, and amortization (EBITDA).
Cash flow and EBITDA point out particularly on the productivity of the company’s actual business operations, independent of external factors such as debt and taxes. Free cash flow, on the other hand, shows the net movement of cash in and out of the company.
To find out free cash flow, equity analysts combine all the company’s incoming cash and then subtract cash that the company is required to pay out, which includes all expenses, debt service, preferred dividends, and capital expenditures. The result shows that how much cash the company was available or how much short of cash the company was at the end of the fiscal period.
In corporate finance, free cash flow (FCF) is cash flow presents for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on.
Profit vs. Cash Flow
A fine way to find out the consideration of cash flow is to match up it to the idea of profit. As a business owner, you become conscious and struggle to make a profit.
If a retail business is competent to buy a retail item for 1,000 Rs. and sell it for 2,000 Rs, then it has ended up with a 1,000 Rs. profit. But what if the purchaser of the retail item is sluggish to forfeit his or her bill, and six months pass before the bill is compensated?
By way of accrual accounting, the retail business still shows a profit, but what about the bills it has to pay for the period of the six months that exceed? It will not have the cash to pay them, even with the profit earned on the sale.
As you know how to notice, profit and cash flow are two totally dissimilar concepts, each with fully unusual results. The concept of profit is somewhat contracted and only looks at income and expenses at a definite point in time. Cash flow, conversely, is more forceful and active. It states the movement of money in and out of a business. More prominently, it is alarmed with the time at which the movement of the money takes place. You may yet say the concept of cash flow is more in line with reality, if you apply the accrual accounting system; it is supportive to know how to convert your accrual profit to your cash flow profit.
The main purpose of this study is to highlight the effects of free cash flows on firm’s profitability the reason why free cash flow is an important variable to look at is because if the company is experiencing negative cash flow, then they will have to look elsewhere for funds to even think about growing the business. Cash rich firms, however, experience asset efficiency improvements while cash poor firms’ asset efficiency get worse usually after mergers.Jensen’s finding has supported both free cash flow and capital structure, as well as efficiency-based, forecasts on performance.
The classification of free cash flow varies depending on the purpose of the study for which it is being used. There are many ways to calculate free cash flow, but possibly the simplest is to take away a company’s capital expenditures from its cash flow from operations.
Some analysts believe that free cash flow is more significant than other procedures of monetary health because it measures how much cash a company has and can make. This differs from other measures, which are sometimes accuse of using both justifiable and unlawful forms of accounting to make a company look improved than it really is.
It is essential to note that negative free cash flow is not awful in itself. If free cash flow was negative, it could be a symbol that a company was making great investments. If these investments receive a high return, the strategy has the possibility to pay off in the long run.
In this study we have taken seven years data of seven different listed companies of oil and gas marketing and exploration sector. We have taken data from state bank web site from the year 2002 to 2008.So our studies is basically on oil and gas sector of Pakistan as this sector is growing very fast since many years.
According to McConnell and Muscarella in (1985) declared capital spending increase by oil and gas exploration firms between 1975 and 1981 showed negative short-term stock price reactions. Lang (1991) found that bidder companies stock returns about corporate mergers and acquisitions were negatively related to the free cash flow of those bidders having unfortunate investment opportunities.
According to 1986 American Economic Review, Michael Jensen stated that free cash flows permitted firms’ managers to fund project that were earning low returns which as a result might not be funded by the equity markets. Considering the US oil industry, which had gained considerable free cash flows in the 1970s and near the beginning of 1980s, Jensen wrote in 1984 that cash flows of the ten biggest oil companies were $48.5 billion, 28 percent of the total cash flows of the top 200 firms in Dun’s Business Month survey. Constant with the agency costs of free cash flow, management did not pay out the surplus resources to shareholders. As an alternative, the industry carried on to spend a lot on exploration and expansion activity even though average returns were below the cost of capital.
In January 2006 according to Oil and Gas Journal (OGJ), Pakistan had proven oil reserves of 300 million barrels; the country’s oil sector is keeping pace by the Ministry of Petroleum and Natural Resources. The Ministry funding oil concessions by open tender and by private negotiation.Pakistan is a significant energy consumer and an important country in the security of South Asia.
The oil and gas sector has an extensive impact on the economy, the sector create a center of attention by far the highest level of foreign direct investments in the country.
This research will be inspected the effects free cash flow levels on the firm’s performance. It will apparent that the cash flow in surplus of that required to fund all positive net present value projects, free cash flow must be paid to shareholders if the firm is to make the most of values and significant tax income for the government
Jensen(1986) cross-sectional regressions show a important relationship between the changes in operating performance and growth opportunities and free cash flow of the asset buyers, usually operating performance changes are negatively associated with free cash flow for buyers with fewer growth opportunities. Even though the coefficient of free cash flow is also negative for high- growth firms, free cash flow has lower economic and statistical significance than in the case of low-growth firm.
Jensen 1986 free cash flows theory anticipated that managers of firms with high free cash flow, particularly with low growth opportunities, are likely to make value demolishing mergers. Jensen, 1986 stated that “debt formation allows managers to successfully bond their promise to pay out free cash flows.”
Some accounting studies analyzed the reported accounting statements of firms before and after the mergers. Bruner (2002) studied fifteen studies from 1977 to 2002 on the reported financial performance of M&A companies. Bruner analyzed that “four studies reported considerably negative performance post acquirement, three studies reported considerably positive performance and so forth (eight) are in the non-significant middle ground.” A number of theoretical clarifications were sought to give insight as to why mergers are beneficial or harmful to shareholder wealth.
According to the Survey by Vu, Joseph D. in his research paper free cash flow and long run firm value analyzed the impact that large free cash flow levels have on the long-term market performance of firms. He stated clearly as cash flow in surplus are required for funding all positive net present value projects, free cash flow must be paid to shareholders if the firm is to take full advantage of value.
Jensen’s (1986) free cash flow hypothesis argued that market pressures gave confidence to managers to share out free cash flow to shareholders or risk losing to deal with the firm.
Therefore, Jensen’s hypothesis determined that stock prices of firms with positive free cash flow should boost eventually as management is pressured to enlarge payouts to corporate shareholders. On the contrary, if management fails to raise payouts and in its place wastes free cash flow on unprofitable investment expenses, the free cash flow hypothesis predicts more declined of firm value.
Research has generated numerous lines of confirmation to underneath the free cash flow hypothesis. First, rise in cash payouts are met by positive short-term share price responses, frequently in a way constant by the free cash flow hypotheses.
Charest (1978) determined that stock returns are negative when the company cut the dividend and are positive when the dividends were increased. Brickely (1983) suggested that common stock prices respond positively to increases in particularly selected dividends. Despite the fact that both studies offered evidence consistent with Jensen’s hypothesis, they are also consistent with the analysis that managers indicated positive information during changes in payout policy.
Lang and Litzenberger (1989) suggested stronger support for free cash flows so Lang and Litzenberger (1989) found that the positive share price response related with dividend increases was intense in firms having poor investment opportunities , on the other hand, Denis (1994) have challenged the Lang and Litzenberger (1989) study’s interpretation. Finally, Nohel and Tarhan (1998) found that the operating performance of firms following to tender offer share repurchases got better only in low-growth firms, and these improvements are generated by more proficient use of assets rather than improved investment opportunities. Nohel and Tarhan (1998) suggested that share repurchases were used as a part by and large reformed packages meant to removing inefficiencies related with free cash flow rather as a indication of new investment opportunities.
Second proof for supporting the free cash flow hypothesis is that capital spending increases are negatively associated with short-term stock price responses among firms with poor investment opportunities.
McConnell and Muscarella (1985) found that announced capital spending increases by oil and gas exploration firms between 1975 and 1981 exhibited negative short-term stock price responses. Lang and Litzenberger (1991) found that bidder firm stock returns around corporate mergers and acquisitions were negatively related to the free cash flow of those bidders having poor investment opportunities. Finally, Vogt (1997) found that positive stock price responses to announced capital spending decisions were concentrated in firms with positive investment opportunities. All of the above studies details results that are consistent with the free cash flow hypothesis.
Jenson Agency Theory
According to Chamber and Lacey in 1999 argued that Agency theory was the theory that was linked to agency problems sourced by the organizational cash flows between managers and shareholders or benefit conflicts. In the firms there were agent costs which were classified under observation costs pursued to reduce agency problems, agreement costs ensuring guaranty and unpreventable losses’ cost.
Capital structure decisions should be taken to diminish agent costs, to decrease agent costs of equity capital with high leverage level thus increase market value of the firm (Berger, 2002).
Conflicts between Managers and Share holders:
Agency theory portrayed the fundamental problems in an organization that is self-interested behavior. Self interested behavior was usually direct to an unfavorable effect on any organization which was by and large for the purpose of getting highest share holder wealth. Company managers could have personal objectives that compete with the owner’s objective of maximization of shareholder wealth. Since the shareholders approved managers to administer the firm’s assets, a possible difference of interest occurred between the two groups.
Agency theory argued that, in imperfect capital and labor markets, managers were trying to find make best use of their own values without regard for corporate shareholders. Agents have the capability to manage their own self-interest comparatively more then the best interests of the firm because of asymmetric information (e.g., managers know better than shareholders either they are talented and capable of meeting the shareholders’ objectives and vagueness. Facts of self-interested managerial behavior involves the utilization of some business resources in the form of perks , bonus and the elusion of greatest risk positions, whereby risk-averse managers stay away from profitable chance in which the firm’s shareholders would desire they invest. Outside investors would be well-known with the firm will make decisions opposite to their best interests, so the investors will diminish the prices they are ready to pay for the firm’s securities.
A probable agency argument come when the executive of a firm own less than 100% of the firm’s common stock. If a firm is individually owned proprietorship then the owner will take on actions to make the most of his or her own interests. The owner will probably presume utility by means of personal wealth, but may control on other contemplations, like spare time and benefits, against personal wealth. If the owner-manager gives up a part of his or her ownership by selling some of the firm’s stock to outside investors, a likely clash and differences of interest, called an agency conflict, take place. If the owner might consider extremely freedom lifestyle and do not work as tough to enlarge shareholder wealth, because less of the wealth will now give confidence to the manager. As well, the proprietor might decide to utilize more privileges, because some of the cost of the spending of profit will now be borne by the outside shareholders.
Usually, a large publicly traded company engages in agency conflicts that are extremely important because the managers generally get hold on only some percentage of common stock. So the shareholder wealth rises can be subordinated to a group of other managerial objectives. For example proprietors may have a main purpose of raising the size of the firm by generating a fast growing firm owners increase their own position, and can create more resources and opportunities for center or lower level managers their salaries and job security can also enlarge, because an unwelcoming invasion are less likely.
Consequentially, nearby management might follow diversification at the expense of the shareholders who may just branch out their individual portfolios through merely buying shares of other companies.
Managers might be positive to act in the stockholders’ best interests by encouragement or by punishments and constraints. Such techniques are how ever helpful only when shareholders may study all the steps in use by the managers. A difficulty or confusion might happen when agents make unobserved actions for their own self-interests it take place because it is not easy for shareholders to watch all managerial actions, to defeat the moral risk or danger problems so the stockholders have to tolerate agency costs.
Cost of share holder management conflict
The agency cost was associated with a 1976 Journal of finance paper by Michael Jensen and William Meckling it was that cost which smooth the progress of managers to boost share holder wealth and agency cost tolerates by share holders just for the reason to support managers rather then manager employ it for their own self interest.
The agency cost is of three most important types, one is audit cost it is an expense which is for examining the managerial activities. Two is employed for the control of unwanted managerial behavior comparable to reforming the company’s business units and hierarchy of administration. Three is opportunity costs which are used when shareholder required boundaries for instance need for shareholder votes on exacting issues, limit the ability of managers to take actions that carry on shareholder wealth.
In the nonattendance of hard work by shareholders to change managerial behavior, there will naturally be some defeat of shareholder wealth because of unsuitable managerial actions. Then again, agency costs would be extreme if shareholders challenge to make sure that every managerial action conformed to shareholder interests. For that reason, the most favorable amount of agency costs to be borne by shareholders is resolute in a cost-benefit situation, agency costs should be enlarged as long as each incremental dollar used up, results in at least a dollar add to shareholder wealth.
Mechanisms for dealing with shareholder-manager conflicts
There were two glacial positions to trade with shareholder-manager agency conflicts. At one intense, the firm’s managers are remunerated totally on the base of stock price modifies. In this case, agency costs will be small because managers have great motivation to maximize shareholder wealth. It would be extremely hard, on the other hand, to hire talented executives under these contractual terms because the firm’s earnings would be exaggerated by economic events that are not beneath managerial control. At the other extreme, stockholders could observe every managerial action, but this would be tremendously costly and incompetent. The most favorable solution lies between the boundaries, where executive return is tied to performance, but several checking is also undertaken. In adding up to observing, the following mechanisms give confidence to managers to act in shareholders’ interests:
(1) Performance-based incentive plans
(2) Direct intervention by shareholders
(3) The threat of firing
(4) The threat of takeover.
At present the majority publicly traded firms utilize performance shares, which are shares of stock specified to executives on the root of performances as clear by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If company performance is on top of the performance targets, the firm’s managers make more shares. If performance is underneath the target, on the other hand, they take delivery of less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are intended to gratify two objectives. First, they propose executives incentives to take accomplishments that will improve shareholder wealth. Second, these plans assist companies to be a focus for and keep hold of managers who have the self-assurance and confidence to risk their financial future on their own capabilities which should direct to better performance.
Dennis E. Logue theory
According to Dennis E. Logue and T.Carig Tapley in his performance Monitoring and the timings of cash flows journal in 1985 states the theoretical importance of net present value and its importance for investors net present value incorporates all financing as well as dividend decisions Dennis E Logue in his paper also discuss the major reasons why firms some time not consider net present value criteria for the investment decision and depends heavily on the patterns and timings of potential project’s cash flows and make decision on early arrivals of these cash flows .
In the first part Dennis E.Logue discuss the capital budgeting decision criteria used by firms and agency cost explanation of firms deviation from received theory. This includes the discussion of timings and patterns of projected cash flows and interaction of firm and capital market.
In the next part Dennis E.Logue discuss the firm’s dividend decision and the agency cost and performance monitoring concept which is analyzed for the decision making process and the final part of his paper explains the summary of whole paper.
Capital budgeting decisions
According to Dennis E.logue and T.Craig in 1985 conclude that a “right” net present value must involve the cost of those individual who are responsible for the project as well as the cost of monitoring the performance of project itself, so the end will nothing more then the agent’s agency problem in that case senior managers must analysis the performance of subordinates. To make it correctly, all information must be gathered properly and one type of sample information that starts automatically is the dissimilarities between project’s actual and expected cash flows patterns. Such information are important when the project’s near term cash flows are expected to be positive, since it may reduce , since it has not been eliminated the need to collect further information regarding a project’s implementations. When the early cash flows are positive then the comparisons of actual and expected cash flows are more valuable. No further investigation is usually conducted when a company expects positive cash flows and achieves its expectations. The qualities of the project and its manager have passed the doorstep that satisfies senior manager. Similarly when a project’s expected cash flows are optimistic or positive and actual cash flows are unhelpful or negative then the company knows at once that some thing is wrong. It can then either proceed or discard, depending on the result of further investigation. In contrast when prospects are negative for more
Than many years and expectations are met one can only conclude that things are according to plan by analyzing a large many more data than is provided by the cash flows.
Ford Motor Company, if have undertaken the improvement of Edsel. Ford motors have invested a large deal over a two-year time, expecting positive cash flows to result. When the positive cash flows did not appear, the product was withdrawn and the project discarded. In this case Ford loses in a relatively shorter period, because the difference
Between expected and actual cash flows generate in depth examination of the project.
According to Dennis E.Logue and T.craig Tapley there is a problem of performance monitoring which is much more sever in large firms because large firms are usually more financially sophisticated than small firms thus in that case the senior manager must monitor the performance of their subordinates. To monitor the performance of projects and subordinates senior manger must be care full about timely and relevant information.
The relationship between actual and expected cash flows may also give valuable information about whether or not a project should be neglected. for example , if a project has intermediate cash flows that do not meet expectation, then this may drive the re-estimation of future cash flows.
It is also possible that a project with intermediate cash flows decrease valuable informational between management and share holder since the impact of these cash flows on the firm’s profitability and so the earning will be directly observed by investors. so as to reduce the transaction cost linked with the sale of new securities, so there would be a poor measurable performance if the project is profitable but it would not generate any intermediate cash flows.
Many Canadian studies have bee conducted for the purpose to determine the operating performance of Canadian acquirers by Eckbo and Thorburn during the period 1996 to 2000.Similarly the essential purpose is to look at explanations from Jensen’s (1986) free cash flow theory on acquirer performance. First, Jenson’s investigate whether the managers of firms with large cash reserves and low growth opportunities make value-destroying mergers. This prediction has found empirical support in the US literature (Lang et al., 1991, Harford, 1999; Freund et al., 2003) but has not with UK firms (Gregory, 2005). However, Jensen’s (1986) other prediction that leverage increasing mergers would improve performance has not been examined before. Jensen’s (1986) free cash flow theory explains the importance of the role of debt in motivating organizational efficiency. Furthermore Canadian studies have found that cash rich firms practice major decline in operating and efficiency performance after their acquisitions. Thus, findings were supported for the free cash flow hypothesis in Canada.
Second, Canadian studies have found that leverage rising acquisitions do improve operating performance. There is an important difference in presentation between leverage increasing and decreasing acquisitions. Thus, Canadian studies by Eckbo and Thorburn extended the studies of Lang et al. (1991), Harford (1999) and Freund et al. (2003) by showing that not only does free cash flow gave details acquirer performance, but also changes in capital structure gave details of performance. These results are strong as regression analyses show related results. This finding implied that increasing liability in acquisitions was useful in reducing the agency costs of free cash flow on wasteful projects. Third, cash rich firms experienced asset efficiency improvements while cash poor firms’ asset efficiency declined after merger, on average. Jenson finding were supported both free cash flow and capital structure, as well as efficiency-based, predictions on performance.
Gregory (2005) examined the long run market abnormal returns of a sample of 1984 to1992 acquirers from the United Kingdom. Gregory (2005) found no support for the free cash flow hypothesis, and in contrast, found that high free cash flow firms show better market performance than low free cash flow firms.
Agency theory views suggested that firm value might be lost through agency costs which include monitoring costs for the principal, bonding costs for the agent, and the residual loss in welfare when the decisions of the agent diverges from the interests of the share-owners (Jensen & Meckling, 1976).
Jensen and Smith (1985) said that a main source of conflict between managers and claimholders were that since investment in firm specific human capital represented a significant portion of the manager’s wealth, Jensen and Smith (1985) were concerned about the total risk of the firm even though the shareholder can diversify away most of that risk. As a result, a manager could make investment decisions that help diversify the firm but might not be in the best interest of shareholders.
Free Cash Flow in the Life Insurance Industry
Jensen (1986) argued that the survival of free cash flow provide managers an opportunity to waste cash on unprofitable investments. These unprofitable investments stand for an incremental cost of the owner-manager conflict.
Mayers and Smith (1981) predicted that the costs of calculating the owner-manager conflict are higher for mutual insurers than for stock insurers because smaller amount of observing and controlling mechanisms were available for the mutual organization. Mayers and Smith (1981) examined the relation between organizational form and free cash flow, and found that mutual insurers do have a greater level of free cash flow than stock insurers. Other firm specific variables, such as size and leverage, also affect the level of free cash flow for the firms.
Jenson 1986 argued that, in the life insurance industry, wasteful uses of free cash flow were raised to the loss of the firm’s owners and policyholders. Managerial aggression for free cash flow was contradictory with the goal of owner wealth maximization.
To the point that regulators supervise life and health insurance rates, dividends, and surrender values, free cash flow should be of concern to them.
Mayers and Smith (1981) predict stricter owner-manager conflicts in mutual insurers than in stock insurers, Mayers and Smith (1981) tested their forecast using data from the life insurance industry.
Mayers and Smith (1981) analyzed that the financial industry had been ignored in most studies because of its unique regulatory environment. The insurance industry, in particular, has distinctly different organizational forms not found in other industries Mayers and Smith, 1990 in their study, test for differences in free cash flow between stock and mutual insurers in the U.S. life insurance industry, with the purpose to examine whether organizational form affects managerial behavior with respect to the holding of free cash flow. Evidence of differences in free cash flow between stock and mutual insurers should be of interest to investors, policyholders, and regulators. If one organi-zational form provides fewer managerial constraints to abusing free cash flow than another, then regulators should potentially incorporate information about the cash distribution policies of firms having that corporate structure in their analysis of insurers.Policyholders and investors should be interested in knowing which type of organizational form better aligns managerial incentives with their interests.
Jensen and Meckling identify two primary types of agency costs: agency costs of equity and agency costs of debt or fixed claims. Agency costs of equity exist between the owners and managers of the firm. When a manager is the sole owner of the firm, he or she holds a 100 percent interest in the success of the firm, and therefore will seek to maximize his or her utility by choosing the level of both firm value and non financial benefits.
Pecking Order Theory
Myers and Majluf in 1984 were build up Pecking order theory
In which they quoted that companies prioritize their basis of financing towards equity rather then internal financing as a result , Pecking Order Theory suggested that internal funds were used first, and when that were of no use then debt were mattered, and when it was not rational to issue any more debt then equity were mattered. T
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