Over-investment of free cash flow
Scott Richardson
documented evidenceUniversity of Pennsylvania
Wharton School
1314 Steinberg Hall – Dietrich Hall
Philadelphia, PA 19104-6365
Phone (215) 898-2063
Fax (215) 573-2054
Email scottric@wharton.upenn.edu
November 10, 2005
Over-investment of free cash flow
ABSTRACT
This paper examines the extent of firm level over-investment of free cash flow.  Using an accounting based framework to measure over-investment and free cash flow, I find evidence that, consistent with agency cost explanations, over-investment is concentrated in firms with the highest levels of free cash flow.  Further tests examine whether firms’ governance structures are associated with over-investment of free cash flow.  The evidence suggests that certain governance structures, such as the presence of activist shareholders, appear to mitigate over-investment.
Keywords: free cash flow, over-investment, agency costs.
Data availability: Data are available from the sources defined in the text.
1. Introduction
This paper examines firm investing decisions in the presence of free cash flow.  In theory, firm level investment should not be related to internally generated cash flows (Modigliani and Miller, 1958).  However, prior research has documented a positive relation between investment expenditure and cash flow (e.g., Hubbard, 1998).  There are two interpretations for this positive relation.  First, the positive rel
ation is a manifestation of an agency problem, where managers in firms with free cash flow engage in wasteful expenditure (e.g., Jensen 1986 and Stulz 1990).  When managers’ objectives differ from those of shareholders, the presence of internally generated cash flow in excess of that required to maintain existing assets in place and finance new positive NPV projects creates the potential for those funds to be squandered.  Second, the positive relation reflects capital market imperfections, where costly external financing creates the potential for internally generated cash flows to expand the feasible investment opportunity set (e.g., Fazzari, Hubbard and Petersen 1988 and Hubbard, 1998).
This paper focuses on utilizing accounting information to better measure the constructs of free cash flow and over-investment, thereby allowing a more powerful test of the agency based explanation for why firm level investment is related to internally generated cash flows.  In doing so, this paper is the first to offer large sample evidence of over-investment of free cash flow.  Prior research, such as Blanchard, Lopez-di-Silanes and Vishny (1994), document excessive investment and acquisition activity for eleven firms that experience a large cash windfall due to a legal settlement, Harford (1999) finds using a sample of 487 takeover bids, that cash rich firms are more likely to make acquisitions that subsequently experience abnormal declines in operating performance, and Bates (2005) finds for a sample of 400 subsidiary sales from 1990-1998 that
firms who retain cash tend to invest more relative to industry peers.  I extend these small sample findings by showing over-investment of free cash flow is a systematic phenomenon across all types of investment expenditure.
The empirical analysis proceeds in two stages.  First, the paper uses an accounting based framework to measure both free cash flow and over-investment.  Free cash flow is cash flow beyond what is necessary to maintain assets in place and to finance expected new investments.  Over-investment is defined as investment expenditure beyond that required to maintain assets in place and to finance expected new investments in positive NPV projects.  To measure over-investment, I decompose total investment expenditure into two components: (i) required investment expenditure to maintain assets in place, and (ii) new investment expenditure.  I then decompose new investment expenditure into over-investment in negative NPV projects and expected investment expenditure, where the latter varies with the firm’s growth opportunities, financing constraints, industry affiliation and other factors.
Under the agency cost explanation, management has the potential to squander free cash flow only when free cash flow is positive.  At the other end of the spectrum, firms with negative free cash flow can only squander cash if they are able to raise “cheap” capital.  This is less likely to occur because these firms need to be able to raise financing and thereby place themselves under the scrutiny of exter
nal markets (Jensen, 1986 and DeAngelo, DeAngelo and Stulz, 2004).  Consistent with the agency cost explanation, I find a positive association between over-investment and free cash flow for firms with positive free cash flow.1  For a sample of 58,053
1 Prior work in finance and economics examining the relation between cash flow and investment expenditure has tended to use either balance sheet measures of the stock of cash and cash equivalents (e.g., Harford, 1999) or earnings based measures as a proxy for cash flow (e.g., Lang, Stulz and Walkling, 1991 and Opler and Titman, 1993).  It is well known that earnings and cash flows are not equivalent measures (e.g., Sloan, 1996).  This paper seeks to measure free cash flow directly using information from the statement of cash flows as opposed to noisy combinations from the income statement and balance sheet.
firm-years during the period 1988-2002, I find that for firms with positive free cash flow the average firm over-invests 20 percent of its free cash flow.  Furthermore, I document that the majority of free cash flow is retained in the form of financial assets.  The average firm in my sample retains 41 percent of its free cash flow as either cash or marketable securities.  There is little evidence that free cash flow is distributed to external debt holders or shareholders.
Finding an association between over-investment and free cash flow is consistent with recent research documenting poor future performance following firm level investment activity.  For example, Titman, Wei and Xie (2004) and Fairfield, Whisenant and Yohn (2003) show that firms with extensive capital investment activity and growth in net operating assets respectively, experience inferior future stock returns.  Furthermore, Dechow, Richardson and Sloan (2005) find that cash flows retained within the firm (either capitalized through accruals or “invested” in financial assets) are associated with lower future operating performance and future stock returns.  This performance relation is consistent with the over-investment of free cash flows documented in this paper.
The second set of empirical analyses examine whether governance structures are effective in mitigating over-investment.  Prior research has examined the impact of a variety of governance structures on firm valuation and the quality of managerial decision making (see Brown and Caylor, 2005, Gompers, Ishii and Metrick, 2003, and Larcker, Richardson and Tuna, 2005 for detailed summaries).  Collectively, the ability of cross-sectional variation in governance structures to explain firm value and/or firm decision making is relatively weak.  Consistent with this, I find evidence that out of a large set of governance measures only a few are related to over-investment.  For example, firms with activist shareholders and certain anti-takeover provisions are less likely to over-invest their free cash flow.

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