Agency Costs of Free Cash Flow,Corporate Finance,Takeovers.doc

agencycostsoffreecashflow,corporatefinance,andtakeoversmichaelc.jensenamericaneconomicreview,may1986,vol.76,no.2,pp.323-329.corporatemanagersaretheagentsofshareholders,arelationshipfraughtwithconflicting interests.agencytheory,theanalysisofsuchconflicts,isnowamajorpartoftheeconomicsliterature.thepayoutofcashtoshareholderscreatesmajorconflictsthathavereceivedlittleattention.payoutstoshareholdersreducetheresourcesundermanagers control,therebyreducingmanagers power,andmakingitmorelikelytheywillincurthemonitoringofthecapitalmarketswhichoccurswhenthefirmmustobtainnewcapital(seeeasterbrook,1984,androzeff,1982).financingprojectsinternallyavoidsthismonitoringandthepossibilitythefundswillbeunavailableoravailableonlyathighexplicitprices.managershaveincentivestocausetheirfirmstogrowbeyondtheoptimalsize.growthincreasesmanagers powerbyincreasingtheresourcesundertheircontrol.itisalsoassociatedwithincreasesinmanagers compensation,becausechangesincompensationarepositivelyrelatedtothegrowthinsales(seemurphy,1985).the tendencyoffirmstorewardmiddlemanagersthroughpromotionratherthanyear-to-yearbonusesalsocreatesastrongorganizationalbiastowardgrowthtosupplythenewpositionsthatsuchpromotion-basedrewardsystemsrequire(seebaker,1986).competitionintheproductandfactormarketstendstodrivepricestowardsminimumaveragecostinanactivity.managersmustthereforemotivatetheirorganizationstoincreaseefficiencytoenhancetheproblemofsurvival.however,productandfactormarketdisciplinaryforcesareoftenweakerinnewactivitiesandactivitiesthatinvolvesubstantialeconomicrentsorquasirents.inthesecases,monitoringbythefirmsinternalcontrolsystemandthemarketforcorporatecontrolaremoreimportant.activitiesgeneratingsubstantialeconomicrentsorquasirentsarethetypesofactivitiesthatgeneratesubstantialamountsoffreecashflow.freecashflowiscashflowinexcessofthatrequiredtofundallprojectsthathavepositivenetpresentvalueswhendiscountedattherelevantcostofcapital.conflictsofinterestbetweenshareholdersandmanagersoverpayoutpoliciesareespeciallyseverewhentheorganizationgeneratessubstantialfreecashflow.theproblemishowtomotivatemanagerstodisgorgethecashratherthaninvestingitatbelowthecostofcapitalorwastingitonorganizationinefficiencies.thetheorydevelopedhereexplains1)thebenefitsofdebtinreducingagencycostsoffreecashflows,2)howdebtcansubstitutefordividends,3)why“diversification”programsaremorelikelytogeneratelossesthantakeoversorexpansioninthesamelineofbusinessorliquidation-motivatedtakeovers,4)whythefactorsgeneratingtakeoveractivityinsuchdiverseactivitiesasbroadcastingandtobaccoaresimilartothoseinoil,and5)whybiddersandsometargetstendtoperformabnormallywellpriortotakeover.i.theroleofdebtinmotivatingorganizationalefficiencytheagencycostsofdebthavebeenwidelydiscussed,butthebenefitsofdebtinmotivatingmanagersandtheirorganizationstobeefficienthavebeenignored.icalltheseeffectsthe ”controlhypothesis” fordebtcreation.managerswithsubstantialfreecashflowcanincreasedividendsorrepurchasestockandtherebypayoutcurrentcashthatwouldotherwisebeinvestedinlow-returnprojectsorwasted.thisleavesmanagerswithcontrolovertheuseoffuturefreecashflows,buttheycanpromisetopayoutfuturecashflowsbyannouncinga”permanent” increaseinthedividend.suchpromisesareweakbecausedividendscanbereducedinthefuture.thefactthatcapitalmarketspunishdividendcutswithlargestockpricereductionsisconsistentwiththeagencycostsoffreecashflow.debtcreation,withoutretentionoftheproceedsoftheissue,enablesmanagerstoeffectivelybondtheirpromisetopayoutfuturecashflows.thus,debtcanbeaneffectivesubstitutefordividends,somethingnotgenerallyrecognizedinthecorporatefinanceliterature.byissuingdebtinexchangeforstock,managersarebondingtheirpromisetopayoutfuturecashflowsinawaythatcannotbeaccomplishedbysimpledividendincreases.indoingso,theygiveshareholderrecipientsofthedebttherighttotakethefirmintobankruptcycourtiftheydonotmaintaintheirpromisetomaketheinterestandprincipalpayments.thusdebtreducestheagencycostsoffreecashflowbyreducingthecashflowavailableforspendingatthediscretionofmanagers.thesecontroleffectsofdebtareapotentialdeterminantofcapitalstructure.issuinglargeamountsofdebttobuybackstockalsosetsuptherequiredorganizationalincentivestomotivatemanagersandtohelpthemovercomenormalorganizationalresistancetoretrenchmentwhichthepayoutoffreecashflowoftenrequires.thethreatcausedbyfailuretomakedebtservicepaymentsservesasaneffectivemotivatingforcetomakesuchorganizationsmoreefficient.stockrepurchasesfordebtorcashalsohastaxadvantages.(interestpaymentsaretaxdeductibletothecorporation,andthatpartoftherepurchaseproceedsequaltotheseller staxbasisinthestockisnottaxedatall.)increasedleveragealsohascosts.asleverageincreases,theusualagencycostsofdebtrise,includingbankruptcycosts.theoptimaldebt-equityratioisthepointatwhichfirmvalueismaximized,thepointwherethemarginalcostsofdebtjustoffsetthemarginalbenefits.thecontrolhypothesisdoesnotimplythatdebtissueswillalwayshavepositivecontroleffects.forexample,theseeffectswillnotbeasimportantforrapidlygrowingorganizationswithlargeandhighlyprofitableinvestmentprojectsbutnofreecashflow.suchorganizationswillhavetogoregularlytothefinancialmarketstoobtaincapital.atthesetimesthemarketshaveanopportunitytoevaluatethecompany,itsmanagement,anditsproposedprojects.investmentbankersandanalystsplayanimportantroleinthismonitoring,andthemarketsassessmentismadeevidentbythepriceinvestorspayforthefinancialclaims.thecontrolfunctionofdebtismoreimportantinorganizationsthatgeneratelargecashflowsbuthavelowgrowthprospects,andevenmoreimportantinorganizationsthatmustshrink.intheseorganizationsthepressurestowastecashflowsbyinvestingtheminuneconomicprojectsismostserious.ii.evidencefromfinancialrestructuringthefreecashflowtheoryofcapitalstructureshelpsexplainpreviouslypuzzlingresultsontheeffectsoffinancialrestructuring.mypaperwithcliffordsmith(1985,table2)andsmith(1986,tables1and3)summarizemorethanadozenstudiesofstockpricechangesatannouncementsoftransactionswhichchangecapitalstructure.mostleverage-increasingtransactions,includingstockrepurchasesandexchangeofdebtorpreferredforcommon,debtforpreferred,andincomebondsforpreferred,resultin significantpositiveincreasesincommonstockprices.the2-daygainsrangefrom21.9percent(debtforcommon)to2.2percent(debtorincomebondsforpreferred).mostleverage-reducingtransactions,includingthesaleofcommon,andexchangeofcommonfordebtorpreferred,orpreferredfordebt,andthecallofconvertiblebondsorconvertiblepreferredforcingconversionintocommon,resultinsignificantdecreasesinstockprices.the2-daylossesrangefrom-9.9percent(commonfordebt)to-0.4percent(forcallofconvertiblepreferredforcingconversiontocommon).consistentwiththis,freecashflowtheorypredictsthat,exceptforfirmswithprofitableunfundedinvestmentprojects,priceswillrisewithunexpectedincreasesinpayoutstoshareholders(orpromisestodoso),andpriceswillfallwithreductionsinpaymentsornewrequestsforfunds(orreductionsinpromisestomakefuturepayments).theexceptionstothesimpleleveragechangerulearetargetedrepurchasesandthesaleofdebt(ofallkinds)andpreferredstock.theseareassociatedwithabnormalpricedeclines(someofwhichareinsignificant).thetargetedrepurchasepricedeclineseemstobeduetothereducedprobabilityoftakeover.thepricedeclineonthesaleofdebtandpreferredstockisconsistentwiththefreecashflowtheorybecausethesesalesbringnewcashunderthecontrolofmanagers.moreover,themagnitudesofthevaluechangesarepositivelyrelatedtothechangeinthetightnessofthecommitmentbondingthepaymentoffuturecashflows;forexample,theeffectsofdebtforpreferredexchangesaresmallerthantheeffectsofdebtforcommonexchanges.taxeffectscanexplainsomeoftheseresults,butnotall,forexample,thepriceincreasesonexchangeofpreferredforcommon,whichhasnotaxeffects.iii.evidencefromleveragedbuyoutandgoingprivatetransactionsmanyofthebenefitsingoingprivateandleveragedbuyout(lbo)transactionsseemtobeduetothecontrolfunctionofdebt.thesetransactionsarecreatinganeworganizationalformthatcompetessuccessfullywiththeopencorporateformbecauseof advantagesincontrollingtheagencycostsoffreecashflow.in1984,goingprivatetransactionstotaled$10.8billionandrepresented27percentofallpublicacquisitions(bynumber,seegrimm,1984,1985,1986,figs.36and37).theevidenceindicatespremiumspaidaverageover50percent.desirableleveragedbuyoutcandidatesarefrequentlyfirmsordivisionsoflargerfirmsthathavestablebusinesshistoriesandsubstantialfreecashflow(i.e.,lowgrowthprospectsandhighpotentialforgeneratingcashflows)situationswhereagencycostsoffreecashflowarelikelytobehigh.thelbotransactionsarefrequentlyfinancedwithhighdebt;10to1ratiosofdebttoequityarenotuncommon.moreover,theuseofstripfinancingandtheallocationofequityinthedealsrevealasensitivitytoincentives,conflictsofinterest,andbankruptcycosts.stripfinancing,thepracticeinwhichriskynonequitysecuritiesareheldinapproximatelyequalproportions,limitstheconflictofinterestamongsuchsecurities holdersandthereforelimitsbankruptcycosts.asomewhatoversimplifiedexampleillustratesthepoint.considertwofirmsidenticalineveryrespectexceptfinancing.firmaisentirelyfinancedwithequity,andfirmbishighlyleveragedwithseniorsubordinateddebt,convertibledebtandpreferredaswellasequity.supposefirmbsecuritiesaresoldonlyinstrips,thatis,abuyerpurchasingxpercentofanysecuritymustpurchasexpercentofallsecurities,andthesecuritiesare”stapled” togethersotheycannotbeseparatedlater.securityholdersofbothfirmshaveidenticalunleveragedclaimsonthecashflowdistribution,butorganizationallythetwofirmsareverydifferent.iffirmbmanagerswithholddividendstoinvestinvalue-reducingprojectsoriftheyareincompetent,stripholdershaverecoursetoremedialpowersnotavailabletotheequityholdersoffirma.eachfirmbsecurityspecifiestherightsitsholderhasintheeventof defaultonitsdividendorcouponpayment,forexample,therighttotakethefirmintobankruptcyortohaveboardrepresentation.aseachsecurityabovetheequitygoesintodefault,thestripholderreceivesnewrightstointercedeintheorganization.asaresult,itiseasierandquickertoreplacemanagersinfirmb.moreover,becauseeverysecurityholderinthehighlyleveragedfirmbhasthesameclaimonthefirm,therearenoconflictsamongseniorandjuniorclaimantsoverreorganizationoftheclaimsintheeventofdefault;tothestripholderitisamatterofmovingfundsfromonepockettoanother.thusfirmbneednevergointobankruptcy,thereorganizationcanbeaccomplishedvoluntarily,quickly,andwithlessexpenseanddisruptionthanthroughbankruptcyproceedings.strictlyproportionalholdingsofallsecuritiesisnotdesirable,forexample,becauseofirsrestrictionsthatdenytaxdeductibilityofdebtinterestinsuchsituationsandlimitsonbankholdingsofequity.however,risklessseniordebtneedntbeinthestrip,anditisadvantageoustohavetop-levelmanagersandventurecapitalistswhopromotethetransactionsholdalargershareoftheequity.securitiescommonlysubjecttostrippracticeareoftencalled”mezzanine”financingandincludesecuritieswithprioritysuperiortocommonstockyetsubordinatetoseniordebt.top-levelmanagersfrequentlyreceive15-20percentoftheequity.venturecapitalistsandthefundstheyrepresentretainthemajorshareoftheequity.theycontroltheboardofdirectorsandmonitormanagers.managersandventurecapitalistshaveastronginterestinmakingtheventuresuccessfulbecausetheirequityinterestsaresubordinatetootherclaims.successrequires(amongotherthings)implementationofchangestoavoidinvestmentinlowreturnprojectstogeneratethecashfordebtserviceandtoincreasethevalueofequity.lessthanahandfuloftheseventureshaveendedinbankruptcy,althoughmorehavegonethroughprivatereorganizations.athoroughtestofthisorganizationalformrequiresthepassageoftimeandanotherrecession.iv.evidencefromtheoilindustryradicalchangesintheenergymarketsince1973simultaneouslygeneratedlargeincreasesinfreecashflowinthepetroleumindustryandrequiredamajorshrinkingoftheindustry.inthisenvironmenttheagencycostsoffreecashflowwerelarge,andthetakeovermarkethasplayedacriticalroleinreducingthem.from1973tothelate1970s,crudeoilpricesincreasedtenfold.theywereinitiallyaccompaniedbyincreasesinexpectedfutureoilpricesandanexpansionoftheindustry.asconsumptionofoilfell,expectationsoffutureincreasesinoilpricesfell.realinterestratesandexplorationanddevelopmentcostsalsoincreased.asaresulttheoptimallevelofrefininganddistributioncapacityandcrudereservesfellinthelate1970sandearly1980s,leavingtheindustrywithexcesscapacity.atthesametimeprofitswerehigh.thisoccurredbecausetheaverageproductivityofresourcesintheindustryincreasedwhilethemarginalproductivitydecreased.thus,contrarytopopularbeliefs,theindustryhadtoshrink.inparticular,crudeoilreserves(theindustrysmajorasset)weretoohigh,andcutbacksinexplorationanddevelopment(e&d)expenditureswererequired(seejensen,1986).priceincreasesgeneratedlargecashflowsintheindustry.forexample,1984cashflowsofthetenlargestoilcompanieswere$48.5billion,28percentofthetotalcashflowsofthetop200firmsindunsbusinessmonthsurvey.consistentwiththeagencycostsoffreecashflow,managementdidnotpayouttheexcessresourcestoshareholders.instead,theindustrycontinuedtospendheavilyone&dactivityeventhoughaveragereturnswerebelowthecostofcapital.oilindustrymanagersalsolauncheddiversificationprogramstoinvestfundsoutsidetheindustry.theprogramsinvolvedpurchasesofcompaniesinretailing(marcorbymobil),manufacturing(relianceelectricbyexxon),officeequipment(vydecbyexxon)andmining(kennecottbysohio,anacondamineralsbyarco,cyprusminesby amoco).theseacquisitionsturnedouttobeamongtheleastsuccessfulofthelastdecade,partlybecauseofbadluck(forexample,thecollapseofthemineralsindustry)andpartlybecauseofalackofmanagementexpertiseoutsidetheoilindustry.althoughacquiringfirmshareholderslostontheseacquisitions,thepurchasesgeneratedsocialbenefitstotheextentthattheydivertedcashtoshareholders(albeittargetshareholders)thatotherwisewouldhavebeenwastedonunprofitablerealinvestmentprojects.twostudiesindicatethatoilindustryexplorationanddevelopmentexpenditureshavebeentoohighsincethelate1970s.mcconnellandmuscarella(1986)findthatannouncementsofincreasesine&dexpendituresintheperiod1975-81wereassociatedwithsystematicdecreasesintheannouncingfirmsstockprice,andviceversa.theseresultsarestrikingincomparisonwiththeirevidencethattheoppositemarketreactionoccurstochangesininvestmentexpendituresbyindustrialfirms,andsimilarsecevidenceonincreasesinr&dexpenditures.(seeofficeofthechiefeconomist,sec1985.)picchisstudyofreturnsone&dexpendituresfor30largeoilfirmsindicatesonaveragetheindustrydidnotearn”.evena10%returnonitspretaxoutlays”(1985,p.5)intheperiod1982-84.estimatesoftheaverageratioofthepresentvalueoffuturenetcashflowsofdiscoveries,extensions,andenhancedrecoverytoe&dexpendituresfortheindustryrangedfromlessthan60to90centsoneverydollarinvestedintheseactivities.v.takeoversintheoilindustryretrenchmentrequirescancellationordelayofmanyongoingandplannedprojects.thisthreatensthecareersofthepeopleinvolved,andtheresultingresistancemeanssuchchangesfrequentlydonotgetmadeintheabsenceofacrisis.takeoverattemptscangeneratecrisesthatbringaboutactionwherenonewouldotherwiseoccur.partlyasaresultofmesapetroleumseffortstoextendtheuseofroyaltytrustswhichreducetaxesandpasscashflowsdirectlythroughtoshareholders,firmsintheoilindustrywereledtomerge,andinthemergingprocesstheyincurredlargeincreasesindebt,paidoutlargeamountsofcapitaltoshareholders,reducedexcessexpendituresine&dandreducedexcesscapacityinrefininganddistribution.theresulthasbeenlargegainsinefficiencyandinvalue.