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Free Cash Flow - Definition

Written by Jason Gordon

Updated at October 22nd, 2020

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Free Cash Flow - Definition   Academic Research on Free Cash Flow Agency costs offree cash flow, corporate finance, and takeovers, Jensen, M. C. (1986). The American economic review,76(2), 323-329. In this paper, a theory is developed relating to 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. The theory explains the benefits of debts in reducing agency costs, how debt can substitute for dividends, why bidders and some targets tend to perform abnormally well prior to takeover, and other issues realting to these conflicts. Over-investment offree cash flow, Richardson, S. (2006). Review of accounting studies,11(2-3), 159-189. This paper examines the extent of firm level over-investment of free cash flow. Using an accounting-based framework to measure over-investment and free cash flow, the paper finds 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. Free cash flowand stockholder gains in going private transactions, Lehn, K., & Poulsen, A. (1989). The Journal of Finance,44(3), 771-787. This paper investigates the source of stockholder gains in going private transactions. It finds support for the hypothesis advanced by Jensen that a major source of these gains is the mitigation of agency problems associated with free cash flow. Using a sample of 263 going private transactions from 1980 through 1987, the results indicate a significant relationship between undistributed cash flow and a firm's decision to go private. The paper aims to show that dividends paid to stockholders are generally unrelated to undistributed cash flows. A test of thefree cash flowhypothesis: The case of bidder returns, Lang, L. H., Walkling, R. A., & Stulz, R. M. (1991). The free cash flow hypothesis advanced by Jensen (1988) states that managers endowed with free cash flow will invest it in negative net present value (NPV) projects rather than pay it out to shareholders. Jensen defines free cash flow as cash flow left after the firm has invested in all available positive NPV projects. This paper tests this hypothesis on a sample of large investments made by firms, namely decisions to acquire control of other firms through tender offers. Dividend announcements:Cash flowsignalling vs.free cash flowhypothesis?, Lang, L. H., & Litzenberger, R. H. (1989). journal of Financial Economics,24(1), 181-191. This study tests the cash flow signalling and free cash flow/overinvestment explanations of the impact of dividend announcements on stock prices. It uses the Tobin's Q ratios less than unity to designate over-investors. The determinants of leveraged buyout activity:Free cash flowvs. financial distress costs, Opler, T., & Titman, S. (1993). The Journal of Finance,48(5), 1985-1999. This paper investigates the determinants of leveraged buyout (LBO) activity by comparing firms that have implemented LBOs to those that have not. The paper shows that firms that initiate LBOs can be characterized as having a combination of unfavorable investment opportunities (low Tobin's q) and relatively high cash flow. LBO firms also tend to be more diversified than firms which do not undertake LBOs. The valuation of corporate R&D expenditures: Evidence from investment opportunities andfree cash flow, Szewczyk, S. H., Tsetsekos, G. P., & Zantout, Z. (1996).Financial Management, 105-110. This study examines the role of investment opportunities and free cash flow in explaining R&D-induced abnormal returns. After controlling for firm size, financial leverage, dividend yield, ownership structure, and industry structure, the study finds a significant positive relation between a firm's Tobin's q and its stock price reaction to announcements of increases in R&D expenditures. The paper finds that R&D-induced abnormal returns are also positively related to the percentage increase in R&D spending, the firm's debt ratio, and institutional ownership. Comparing the accuracy and explainability of dividend,free cash flow, and abnormal earnings equity value estimates, Francis, J., Olsson, P., & Oswald, D. R. (2000). Journal of accounting research,38(1), 45-70. Onetimecash flowannouncements andfree cashflowtheory: Share repurchases and special dividends, Howe, K. M., He, J., & Kao, G. W. (1992). The Journal of Finance,47(5), 1963-1975. Thefree cash flowhypothesis for sales growth and firm performance, Brush, T. H., Bromiley, P., & Hendrickx, M. (2000).Strategic Management Journal,21(4), 455-472. The leading explanation for the positive price response surrounding tender offer share repurchase and specially designated dividend (SDD) announcements is the information signaling hypothesis. This paper reexamines these announcements to determine if Jensen's free cashflow theory also has explanatory power. Earnings management, surplusfree cash flow, and external monitoring, Chung, R., Firth, M., & Kim, J. B. (2005).Journal of business research,58(6), 766-776. This paper analyses the different reasons for which managers engage in earnings management. The paper argues that low-growth companies with high free cash flow (SFCF) will use income-increasing discretionary accruals (DAC) to offset the low or negative earnings that inevitably accompany investments with negative net present values (NPVs). The operating performance of seasoned equity issuers:Free cash flowand post-issue performance, McLaughlin, R., Safieddine, A., & Vasudevan, G. K. (1996). Financial Management, 41-53.

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