Over-investment of free cash flow

Rev Acc Stud (2006) 11:159189

DOI 10.1007/s11142-006-9012-1Over-investment of free cash flowScott RichardsonPublished online: 23 June 2006

Springer Science+Business Media, LLC 2006Abstract This paper examines the extent of firm level over-investment of

free cash flow. Using an accounting-based framework to measure overinvestment 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 costsJEL Classification G3 M4This 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 & 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 relation is a manifestation of an agency problem, where

managers in firms with free cash flow engage in wasteful expenditure (e.g.,

Jensen 1986; 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 externalS. Richardson (&)Wharton School, University of Pennsylvania, 1314 Steinberg HallDietrich Hall,

Philadelphia, PA 19104-6365, USAe-mail: [email protected] S. Richardsonfinancing creates the potential for internally generated cash flows to expand

the feasible investment opportunity set (e.g., Fazzari, Hubbard, & Petersen,

1988; 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...