Agency Costs of Free Cash Flow,Corporate Finance,Takeovers

1、agencycostsoffreecashflow,corporatefinance,andtakeoversmichaelc.jensenamericaneconomicreview,may1986,vol.76,no.2,pp.323-329.corporatemanagersaretheagentsofshareholders,arelationshipfraughtwithconflicting interests.agencytheory,theanalysisofsuchconflicts,isnowamajorpartoftheeconomicsliterature.thepay

2、outofcashtoshareholderscreatesmajorconflictsthathavereceivedlittleattention.payoutstoshareholdersreducetheresourcesundermanagers control,therebyreducingmanagers power,andmakingitmorelikelytheywillincurthemonitoringofthecapitalmarketswhichoccurswhenthefirmmustobtainnewcapital(seeeasterbrook,1984,andr

3、ozeff,1982).financingprojectsinternallyavoidsthismonitoringandthepossibilitythefundswillbeunavailableoravailableonlyathighexplicitprices.managershaveincentivestocausetheirfirmstogrowbeyondtheoptimalsize.growthincreasesmanagers powerbyincreasingtheresourcesundertheircontrol.itisalsoassociatedwithincr

4、easesinmanagers compensation,becausechangesincompensationarepositivelyrelatedtothegrowthinsales(seemurphy,1985).the tendencyoffirmstorewardmiddlemanagersthroughpromotionratherthanyear-to-yearbonusesalsocreatesastrongorganizationalbiastowardgrowthtosupplythenewpositionsthatsuchpromotion-basedrewardsy

5、stemsrequire(seebaker,1986).competitionintheproductandfactormarketstendstodrivepricestowardsminimumaveragecostinanactivity.managersmustthereforemotivatetheirorganizationstoincreaseefficiencytoenhancetheproblemofsurvival.however,productandfactormarketdisciplinaryforcesareoftenweakerinnewactivitiesand

6、activitiesthatinvolvesubstantialeconomicrentsorquasirents.inthesecases,monitoringbythefirmsinternalcontrolsystemandthemarketforcorporatecontrolaremoreimportant.activitiesgeneratingsubstantialeconomicrentsorquasirentsarethetypesofactivitiesthatgeneratesubstantialamountsoffreecashflow.freecashflowisca

7、shflowinexcessofthatrequiredtofundallprojectsthathavepositivenetpresentvalueswhendiscountedattherelevantcostofcapital.conflictsofinterestbetweenshareholdersandmanagersoverpayoutpoliciesareespeciallyseverewhentheorganizationgeneratessubstantialfreecashflow.theproblemishowtomotivatemanagerstodisgorget

8、hecashratherthaninvestingitatbelowthecostofcapitalorwastingitonorganizationinefficiencies.thetheorydevelopedhereexplains1)thebenefitsofdebtinreducingagencycostsoffreecashflows,2)howdebtcansubstitutefordividends,3)why“diversification”programsaremorelikelytogeneratelossesthantakeoversorexpansioninthes

9、amelineofbusinessorliquidation-motivatedtakeovers,4)whythefactorsgeneratingtakeoveractivityinsuchdiverseactivitiesasbroadcastingandtobaccoaresimilartothoseinoil,and5)whybiddersandsometargetstendtoperformabnormallywellpriortotakeover.i.theroleofdebtinmotivatingorganizationalefficiencytheagencycostsof

10、debthavebeenwidelydiscussed,butthebenefitsofdebtinmotivatingmanagersandtheirorganizationstobeefficienthavebeenignored.icalltheseeffectsthe ”controlhypothesis” fordebtcreation.managerswithsubstantialfreecashflowcanincreasedividendsorrepurchasestockandtherebypayoutcurrentcashthatwouldotherwisebeinvest

11、edinlow-returnprojectsorwasted.thisleavesmanagerswithcontrolovertheuseoffuturefreecashflows,buttheycanpromisetopayoutfuturecashflowsbyannouncinga”permanent” increaseinthedividend.suchpromisesareweakbecausedividendscanbereducedinthefuture.thefactthatcapitalmarketspunishdividendcutswithlargestockprice

12、reductionsisconsistentwiththeagencycostsoffreecashflow.debtcreation,withoutretentionoftheproceedsoftheissue,enablesmanagerstoeffectivelybondtheirpromisetopayoutfuturecashflows.thus,debtcanbeaneffectivesubstitutefordividends,somethingnotgenerallyrecognizedinthecorporatefinanceliterature.byissuingdebt

13、inexchangeforstock,managersarebondingtheirpromisetopayoutfuturecashflowsinawaythatcannotbeaccomplishedbysimpledividendincreases.indoingso,theygiveshareholderrecipientsofthedebttherighttotakethefirmintobankruptcycourtiftheydonotmaintaintheirpromisetomaketheinterestandprincipalpayments.thusdebtreduces

14、theagencycostsoffreecashflowbyreducingthecashflowavailableforspendingatthediscretionofmanagers.thesecontroleffectsofdebtareapotentialdeterminantofcapitalstructure.issuinglargeamountsofdebttobuybackstockalsosetsuptherequiredorganizationalincentivestomotivatemanagersandtohelpthemovercomenormalorganiza

15、tionalresistancetoretrenchmentwhichthepayoutoffreecashflowoftenrequires.thethreatcausedbyfailuretomakedebtservicepaymentsservesasaneffectivemotivatingforcetomakesuchorganizationsmoreefficient.stockrepurchasesfordebtorcashalsohastaxadvantages.(interestpaymentsaretaxdeductibletothecorporation,andthatp

16、artoftherepurchaseproceedsequaltotheseller staxbasisinthestockisnottaxedatall.)increasedleveragealsohascosts.asleverageincreases,theusualagencycostsofdebtrise,includingbankruptcycosts.theoptimaldebt-equityratioisthepointatwhichfirmvalueismaximized,thepointwherethemarginalcostsofdebtjustoffsetthemarg

17、inalbenefits.thecontrolhypothesisdoesnotimplythatdebtissueswillalwayshavepositivecontroleffects.forexample,theseeffectswillnotbeasimportantforrapidlygrowingorganizationswithlargeandhighlyprofitableinvestmentprojectsbutnofreecashflow.suchorganizationswillhavetogoregularlytothefinancialmarketstoobtain

18、capital.atthesetimesthemarketshaveanopportunitytoevaluatethecompany,itsmanagement,anditsproposedprojects.investmentbankersandanalystsplayanimportantroleinthismonitoring,andthemarketsassessmentismadeevidentbythepriceinvestorspayforthefinancialclaims.thecontrolfunctionofdebtismoreimportantinorganizati

19、onsthatgeneratelargecashflowsbuthavelowgrowthprospects,andevenmoreimportantinorganizationsthatmustshrink.intheseorganizationsthepressurestowastecashflowsbyinvestingtheminuneconomicprojectsismostserious.ii.evidencefromfinancialrestructuringthefreecashflowtheoryofcapitalstructureshelpsexplainpreviousl

20、ypuzzlingresultsontheeffectsoffinancialrestructuring.mypaperwithcliffordsmith(1985,table2)andsmith(1986,tables1and3)summarizemorethanadozenstudiesofstockpricechangesatannouncementsoftransactionswhichchangecapitalstructure.mostleverage-increasingtransactions,includingstockrepurchasesandexchangeofdebt

21、orpreferredforcommon,debtforpreferred,andincomebondsforpreferred,resultin significantpositiveincreasesincommonstockprices.the2-daygainsrangefrom21.9percent(debtforcommon)to2.2percent(debtorincomebondsforpreferred).mostleverage-reducingtransactions,includingthesaleofcommon,andexchangeofcommonfordebto

22、rpreferred,orpreferredfordebt,andthecallofconvertiblebondsorconvertiblepreferredforcingconversionintocommon,resultinsignificantdecreasesinstockprices.the2-daylossesrangefrom-9.9percent(commonfordebt)to-0.4percent(forcallofconvertiblepreferredforcingconversiontocommon).consistentwiththis,freecashflow

23、theorypredictsthat,exceptforfirmswithprofitableunfundedinvestmentprojects,priceswillrisewithunexpectedincreasesinpayoutstoshareholders(orpromisestodoso),andpriceswillfallwithreductionsinpaymentsornewrequestsforfunds(orreductionsinpromisestomakefuturepayments).theexceptionstothesimpleleveragechangeru

24、learetargetedrepurchasesandthesaleofdebt(ofallkinds)andpreferredstock.theseareassociatedwithabnormalpricedeclines(someofwhichareinsignificant).thetargetedrepurchasepricedeclineseemstobeduetothereducedprobabilityoftakeover.thepricedeclineonthesaleofdebtandpreferredstockisconsistentwiththefreecashflow

25、theorybecausethesesalesbringnewcashunderthecontrolofmanagers.moreover,themagnitudesofthevaluechangesarepositivelyrelatedtothechangeinthetightnessofthecommitmentbondingthepaymentoffuturecashflows;forexample,theeffectsofdebtforpreferredexchangesaresmallerthantheeffectsofdebtforcommonexchanges.taxeffec

26、tscanexplainsomeoftheseresults,butnotall,forexample,thepriceincreasesonexchangeofpreferredforcommon,whichhasnotaxeffects.iii.evidencefromleveragedbuyoutandgoingprivatetransactionsmanyofthebenefitsingoingprivateandleveragedbuyout(lbo)transactionsseemtobeduetothecontrolfunctionofdebt.thesetransactions

27、arecreatinganeworganizationalformthatcompetessuccessfullywiththeopencorporateformbecauseof advantagesincontrollingtheagencycostsoffreecashflow.in1984,goingprivatetransactionstotaled$10.8billionandrepresented27percentofallpublicacquisitions(bynumber,seegrimm,1984,1985,1986,figs.36and37).theevidencein

28、dicatespremiumspaidaverageover50percent.desirableleveragedbuyoutcandidatesarefrequentlyfirmsordivisionsoflargerfirmsthathavestablebusinesshistoriesandsubstantialfreecashflow(i.e.,lowgrowthprospectsandhighpotentialforgeneratingcashflows)situationswhereagencycostsoffreecashflowarelikelytobehigh.thelbo

29、transactionsarefrequentlyfinancedwithhighdebt;10to1ratiosofdebttoequityarenotuncommon.moreover,theuseofstripfinancingandtheallocationofequityinthedealsrevealasensitivitytoincentives,conflictsofinterest,andbankruptcycosts.stripfinancing,thepracticeinwhichriskynonequitysecuritiesareheldinapproximately

30、equalproportions,limitstheconflictofinterestamongsuchsecurities holdersandthereforelimitsbankruptcycosts.asomewhatoversimplifiedexampleillustratesthepoint.considertwofirmsidenticalineveryrespectexceptfinancing.firmaisentirelyfinancedwithequity,andfirmbishighlyleveragedwithseniorsubordinateddebt,conv

31、ertibledebtandpreferredaswellasequity.supposefirmbsecuritiesaresoldonlyinstrips,thatis,abuyerpurchasingxpercentofanysecuritymustpurchasexpercentofallsecurities,andthesecuritiesare”stapled” togethersotheycannotbeseparatedlater.securityholdersofbothfirmshaveidenticalunleveragedclaimsonthecashflowdistr

32、ibution,butorganizationallythetwofirmsareverydifferent.iffirmbmanagerswithholddividendstoinvestinvalue-reducingprojectsoriftheyareincompetent,stripholdershaverecoursetoremedialpowersnotavailabletotheequityholdersoffirma.eachfirmbsecurityspecifiestherightsitsholderhasintheeventof defaultonitsdividend

33、orcouponpayment,forexample,therighttotakethefirmintobankruptcyortohaveboardrepresentation.aseachsecurityabovetheequitygoesintodefault,thestripholderreceivesnewrightstointercedeintheorganization.asaresult,itiseasierandquickertoreplacemanagersinfirmb.moreover,becauseeverysecurityholderinthehighlylever

34、agedfirmbhasthesameclaimonthefirm,therearenoconflictsamongseniorandjuniorclaimantsoverreorganizationoftheclaimsintheeventofdefault;tothestripholderitisamatterofmovingfundsfromonepockettoanother.thusfirmbneednevergointobankruptcy,thereorganizationcanbeaccomplishedvoluntarily,quickly,andwithlessexpens

35、eanddisruptionthanthroughbankruptcyproceedings.strictlyproportionalholdingsofallsecuritiesisnotdesirable,forexample,becauseofirsrestrictionsthatdenytaxdeductibilityofdebtinterestinsuchsituationsandlimitsonbankholdingsofequity.however,risklessseniordebtneedntbeinthestrip,anditisadvantageoustohavetop-

36、levelmanagersandventurecapitalistswhopromotethetransactionsholdalargershareoftheequity.securitiescommonlysubjecttostrippracticeareoftencalled”mezzanine”financingandincludesecuritieswithprioritysuperiortocommonstockyetsubordinatetoseniordebt.top-levelmanagersfrequentlyreceive15-20percentoftheequity.v

37、enturecapitalistsandthefundstheyrepresentretainthemajorshareoftheequity.theycontroltheboardofdirectorsandmonitormanagers.managersandventurecapitalistshaveastronginterestinmakingtheventuresuccessfulbecausetheirequityinterestsaresubordinatetootherclaims.successrequires(amongotherthings)implementationo

38、fchangestoavoidinvestmentinlowreturnprojectstogeneratethecashfordebtserviceandtoincreasethevalueofequity.lessthanahandfuloftheseventureshaveendedinbankruptcy,althoughmorehavegonethroughprivatereorganizations.athoroughtestofthisorganizationalformrequiresthepassageoftimeandanotherrecession.iv.evidence

39、fromtheoilindustryradicalchangesintheenergymarketsince1973simultaneouslygeneratedlargeincreasesinfreecashflowinthepetroleumindustryandrequiredamajorshrinkingoftheindustry.inthisenvironmenttheagencycostsoffreecashflowwerelarge,andthetakeovermarkethasplayedacriticalroleinreducingthem.from1973tothelate

40、1970s,crudeoilpricesincreasedtenfold.theywereinitiallyaccompaniedbyincreasesinexpectedfutureoilpricesandanexpansionoftheindustry.asconsumptionofoilfell,expectationsoffutureincreasesinoilpricesfell.realinterestratesandexplorationanddevelopmentcostsalsoincreased.asaresulttheoptimallevelofrefininganddi

41、stributioncapacityandcrudereservesfellinthelate1970sandearly1980s,leavingtheindustrywithexcesscapacity.atthesametimeprofitswerehigh.thisoccurredbecausetheaverageproductivityofresourcesintheindustryincreasedwhilethemarginalproductivitydecreased.thus,contrarytopopularbeliefs,theindustryhadtoshrink.inp

42、articular,crudeoilreserves(theindustrysmajorasset)weretoohigh,andcutbacksinexplorationanddevelopment(e&d)expenditureswererequired(seejensen,1986).priceincreasesgeneratedlargecashflowsintheindustry.forexample,1984cashflowsofthetenlargestoilcompanieswere$48.5billion,28percentofthetotalcashflowsoftheto

43、p200firmsindunsbusinessmonthsurvey.consistentwiththeagencycostsoffreecashflow,managementdidnotpayouttheexcessresourcestoshareholders.instead,theindustrycontinuedtospendheavilyone&dactivityeventhoughaveragereturnswerebelowthecostofcapital.oilindustrymanagersalsolauncheddiversificationprogramstoinvest

44、fundsoutsidetheindustry.theprogramsinvolvedpurchasesofcompaniesinretailing(marcorbymobil),manufacturing(relianceelectricbyexxon),officeequipment(vydecbyexxon)andmining(kennecottbysohio,anacondamineralsbyarco,cyprusminesby amoco).theseacquisitionsturnedouttobeamongtheleastsuccessfulofthelastdecade,pa

45、rtlybecauseofbadluck(forexample,thecollapseofthemineralsindustry)andpartlybecauseofalackofmanagementexpertiseoutsidetheoilindustry.althoughacquiringfirmshareholderslostontheseacquisitions,thepurchasesgeneratedsocialbenefitstotheextentthattheydivertedcashtoshareholders(albeittargetshareholders)thatot

46、herwisewouldhavebeenwastedonunprofitablerealinvestmentprojects.twostudiesindicatethatoilindustryexplorationanddevelopmentexpenditureshavebeentoohighsincethelate1970s.mcconnellandmuscarella(1986)findthatannouncementsofincreasesine&dexpendituresintheperiod1975-81wereassociatedwithsystematicdecreasesin

47、theannouncingfirmsstockprice,andviceversa.theseresultsarestrikingincomparisonwiththeirevidencethattheoppositemarketreactionoccurstochangesininvestmentexpendituresbyindustrialfirms,andsimilarsecevidenceonincreasesinr&dexpenditures.(seeofficeofthechiefeconomist,sec1985.)picchisstudyofreturnsone&dexpen

48、dituresfor30largeoilfirmsindicatesonaveragetheindustrydidnotearn”.evena10%returnonitspretaxoutlays”(1985,p.5)intheperiod1982-84.estimatesoftheaverageratioofthepresentvalueoffuturenetcashflowsofdiscoveries,extensions,andenhancedrecoverytoe&dexpendituresfortheindustryrangedfromlessthan60to90centsoneve

49、rydollarinvestedintheseactivities.v.takeoversintheoilindustryretrenchmentrequirescancellationordelayofmanyongoingandplannedprojects.thisthreatensthecareersofthepeopleinvolved,andtheresultingresistancemeanssuchchangesfrequentlydonotgetmadeintheabsenceofacrisis.takeoverattemptscangeneratecrisesthatbri

50、ngaboutactionwherenonewouldotherwiseoccur.partlyasaresultofmesapetroleumseffortstoextendtheuseofroyaltytrustswhichreducetaxesandpasscashflowsdirectlythroughtoshareholders,firmsintheoilindustrywereledtomerge,andinthemergingprocesstheyincurredlargeincreasesindebt,paidoutlargeamountsofcapitaltoshareholders,reducedexcessexpendituresine&dandreducedexcesscapacityinrefininganddistribution.theresulthasbeenlargegainsinefficiencyandinvalue.