AGENCY COSTS OF FREE CASH FLOW,
CORPORATE FINANCE, AND TAKEOVERS
Michael C. Jensen
Harvard Business School
mjensen@hbs.edu
Abstract
The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows—more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why “diversification” programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.
© M. C. Jensen, 1986
American Economic Review, May 1986, Vol. 76, No. 2, pp. 323-329.
This document is available on the
Social Science Research Network (SSRN) Electronic Library at:
papers.ssrn/sol3/paper.taf?ABSTRACT_ID=99580
AGENCY COSTS OF FREE CASH FLOW,
CORPORATE FINANCE, AND TAKEOVERS
Michael C. Jensen*
Harvard Business School
Corporate managers are the agents of shareholders, a relationship fraught with conflicting interests. Agency theory, the analysis of such conflicts, is now a major part of the economics literature. The payout of cash to shareholders creates major conflicts that have received little attention.1 Payouts to s
hareholders reduce the resources under managers’ control, thereby reducing managers’ power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital (see M. Rozeff (1982); F. H. Easterbrook (1984)). Financing projects internally avoids this monitoring and the possibility the funds will be unavailable or available only at high explicit prices.
Managers have incentives to cause their firms to grow beyond the optimal size. Growth increases managers’ power by increasing the resources under their control. It is also associated with increases in managers’ compensation, because changes in compensation are positively related to the growth in sales (see Murphy (1985)). The
* Edsel Bryant Ford Professor of Business Administration.  I appreciate the research assistance of Brian Barry, Susan Brumfield, and Steve-Anna Stephens, editorial and substantive comments and help from Don Chew and Karen Wruck, and research support provided by the Division of Research of the Harvard Business School. I bear all responsibilities for errors.
1 Gordon Donaldson (1984) in his study of 1
2 large Fortune 500 firms concludes the managers of these firms were not driven by the maximization
of the value of the firm, but rather by the maximization of “corporate wealth,” defined as “the aggregate purchasing power available to management for strategic purposes during any given planning period” (p. 3). “In practical terms it is cash, credit, and other corporate purchasing power by which management commands goods and services” (p. 22).
tendency of firms to reward middle managers through promotion rather than year-to-year bonuses also creates a strong organizational bias toward growth to supply the new positions that such promotion-based reward systems require (see Baker (1986)).
Competition in the product and factor markets tends to drive prices towards minimum average cost in an activity. Managers must therefore motivate their organizations to increase efficiency to enhance the problem of survival. However, product and factor market disciplinary forces are often weaker in new activities and activities that involve substantial economic rents or quasi rents.2 In these cases, monitoring by the firm’s internal control system and the market for corporate control are more important. Activities generating substantial economic rents or quasi rents are the types of activities that generate substantial amounts of free cash flow.
Free cash flow is cash flow in excess of that required to fund all projects that have positive net present
values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies.
The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why “diversification” programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.
deductible2 Rents are returns in excess of the opportunity cost of the resources to the activity. Quasi rents are returns in excess of the short-run opportunity cost of the resources to the activity.
I.The Role of Debt in Motivating Organizational Efficiency
The agency costs of debt have been widely discussed, but the benefits of debt in motivating managers and their organizations to be efficient have been ignored. I call these effects the “control hypothesis” fo
r debt creation.
Managers with substantial free cash flow can increase dividends or repurchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or wasted. This leaves managers with control over the use of future free cash flows, but they can promise to pay out future cash flows by announcing a “permanent”increase in the dividend. Such promises are weak because dividends can be reduced in the future. The fact that capital markets punish dividend cuts with large stock price reductions is consistent with the agency costs of free cash flow.
Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows. Thus, debt can be an effective substitute for dividends, something not generally recognized in the corporate finance literature. By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increases. In doing so, they give shareholder recipients of the debt the right to take the firm into bankruptcy court if they do not maintain their promise to make the interest and principal payments. Thus debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. These control effects of debt are a potential determinant of capital structure.
Issuing large amounts of debt to buy back stock also sets up the required organizational incentives to motivate managers and to help them overcome normal organizational resistance to retrenchment which the payout of free cash flow often requires. The threat caused by failure to make debt service payments serves as an effective motivating force to make such organizations more efficient. Stock repurchases for debt or cash also has tax advantages. (Interest payments are tax deductible to the
corporation, and that part of the repurchase proceeds equal to the seller’s tax basis in the stock is not taxed at all.)
Increased leverage also has costs. As leverage increases, the usual agency costs of debt rise, including bankruptcy costs. The optimal debt-equity ratio is the point at which firm value is maximized, the point where the marginal costs of debt just offset the marginal benefits.
The control hypothesis does not imply that debt issues will always have positive control effects. For example, these effects will not be as important for rapidly growing organizations with large and highly profitable investment projects but no free cash flow. Such organizations will have to go regularly to the financial markets to obtain capital. At these times the markets have an opportunity to evaluate the company, its management, and its proposed projects. Investment bankers and analysts play an import
ant role in this monitoring, and the market’s assessment is made evident by the price investors pay for the financial claims.
The control function of debt is more important in organizations that generate large cash flows but have low growth prospects, and even more important in organizations that must shrink. In these organizations the pressures to waste cash flows by investing them in uneconomic projects is most serious.
II.Evidence from Financial Restructuring
The free cash flow theory of capital structures helps explain previously puzzling results on the effects of financial restructuring. My paper with Clifford Smith (1985, Table 2) and Smith (1986, Tables 1 and 3) summarize more than a dozen studies of stock price changes at announcements of transactions which change capital structure. Most leverage-increasing transactions, including stock repurchases and exchange of debt or preferred for common, debt for preferred, and income bonds for preferred, result in

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