Ssss Essay

4751 Words Nov 27th, 2013 20 Pages
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 liquidationmotivated takeovers, 4) why the factors
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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
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Gordon Donaldson (1984) in his study of 12 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). * La Claire Professor of Finance and Business Administration and Director of the Managerial Economics Research Center, University of Rochester Graduate School of Management, Rochester, NY 14627, and Professor of Business Administration, Harvard Business School.

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