Free Cash Flow - Research Paper Example

Introduction Operating cash flow is a critical tool in cash flow analysis since it is used as a basis for calculating free cash flow. It also forms a basis of calculating the operating cash flow margin, which provides a crucial perspective for calculating the long-term cost trends of a company. It shows how well the company in consideration is managed compared to its competitors. Free cash flow is a tool that is used to evaluate the cash flow of a business entity. It measures the operating cash flow that is available for use by the company after the purchase of property, plant and equipment (PP&E). It is therefore the cash flow that remains after the firm makes investment in property, plant and equipments. Often, financial analysts consider free cash flow to be more efficient in measuring the strength of a business than the cash flow from operating activities. To remain competitive large companies and other forms of businesses will need to invest in new equipments in order to maintain its competitive nature. These investments affect the level of free cash flow that the business is able to maintain (Yuangchih, 412). The two main hypotheses “This study investigates the ability of Free Cash Flow to predict performance in capital intensive and non-capital intensive industries”. (Nunez, 120). Nunez argues that, “many financial scholars and researchers have focused on studying the effectiveness of operating cash flow as a measure of a firm’s performance although other researchers have proved that free cash flow is a better measure since it greatly considers capital intensity”. “Free cash flow as a measure of a firm’s performance is not easy to manipulate compared to the other measures such as earnings, Nunez states. He further states that, “there are various methods used by different firms in determining their actual free cash flow but there is however no specific guidance given regarding the calculation and this is because its disclosure is not a requirement by the US GAAPs”. “The few firms that report their free cash flow therefore use the operations based method while others use the income based method” (Nunez, 121). Nunez stresses that, “Firms that base their calculation on operations use a capital maintenance perspective whereby free cash flow is calculated as cash flow from operating activities less capital that are necessary to maintain the firm at a productive capacity and this observes the guidance provided in the International Accounting Standards Board (IAS 7)”. “The operations based method also uses a perspective that is all-inclusive, calculating free cash flow as calculated as cash flow from operating activities less capital expenditure plus changes in long-term investment and proceeds from the sale of fixed assets” (Nunez, 122). “Firms in capital intensive industry require a huge investment in capital to start and maintain their productive operation and that investment in capital assets equips these with tools that are essential for carrying out their business operations efficiently”. “The balance sheet of these companies are characterized by high levels of depreciation expense and fixed assets” He insists. Nunez in his study found that the association that prevails between the capital intensity and free cash flow differs for firms that are capital intensive and those that are not capital intensive. This is concluded from one of the hypotheses found in the research and the second hypothesis is the null hypothesis stating that the predictability of free cash flow is not different between firms that are capital intensive and those that are not capital intensive. There are lower levels of free cash flow in firms in the capital intensive industries compared to those in non capital intensive industry and this is because the firms that are capital intensive incur depreciation expenses and the investment cost for the fixed assets” Nunez states. He further states that, “the difference in mean fixed asset ratio between the firms in capital intensive industry and those in non-capital intensive firms explains this”. “The lower levels of free cash flow in capital intensive firms are also evidenced by the correlation coefficient, which is significant at 1 percent level” (Nunez, 126). “The level of correlation coefficient is measured between free cash flow and capital intensity and the Pearson correlation coefficient is significant for firms in non capital intensive industry at1 percent level,” Nunez explains. He further explains, “This is in support of H1and shows the high levels of free cash flow in firms in non capital intensive industry”. Free cash flow in this case, has more performance predictability than net income and operating cash flow for firms in non-capital intensive industry (Nunez, 127). “Free cash flow, Operating cash flow and net income lack significance in capital intensive firms but net income and operating cash flow for non capital intensive firms is significant at 1 percent level,” argues Nunez. He continues to explain, “This indicates that they are better performance measures for firms that are not capital intensive, qualifying free cash flow to having a lower ability for performance predictability”. Free cash flow is significant for firms that are capital intensive while for firms that are not capital intensive, significance is at a level of 1 percent for free cash flow as well as operating cash flow”, Nunez states. Nunez’s study at this point, brings out the ability of free cash flow to predict the performance of firms that are capital intensive. “Operating cash flow and net income are more relevant in predicting performance in non capital intensive firms and the relevance of free cash flow has been observed to be minimal and therefore not efficient to measure and predict performance in non-capital intensive firms”, Nunez explains. “Correlation coefficient, scatter plots used and descriptive statistics are the measures for the two hypotheses”. The data to derive these hypotheses has been derived from a sample population of three firms in the capital intensive industry and three others from non-capital intensive industry. Causes and consequences of leveraged buyout “Leveraged management buyouts (LBOs) in the United States started in 1980s as a form of corporate restructuring” and it takes place when securities of a company cease to be traded in public and instead acquires private ownership”, explains Fox & Marcus (62). Marcus stresses that, “few scholars and researchers have focused on the study of how firms perform after undergoing the LBOs”. “The affairs of LBO are messy because it is usually difficult to determine whether managers have the motivation to manage the operations of the firm efficiently or whether employees are managed using the appropriate ethical standards and whether they receive a fair treatment”, argues Kissan & Vernon. “Many management buyouts that take place are aimed at improving the productivity of the company, are facilitated by buyout specialists and usually aim at achieving huge profits within a short period” (Fox &Marcus, 64). Fox & Marcus further argue that, “debt level is high in the companies that are subject to LBO and this is because the group that is usually undertaking the LBO holds less than 10 percent of equity and therefore must obtain the remaining funds through debt”. He explains that, “they secure the debt using fixed assets, inventory and accounts receivable and this causes a significant change in the debt book value to capital and this means that the debt takes up a large part of the operating cash flow”. “The management undertaking a LBO owns a substantial part of the company and therefore there lacks separation between ownership and control of the company and with the increased control by the management, they tend to increase their interests with those of the owners” (Easterwood, Seth & Singer, 36). The managers also have a large stake in the company and therefore they become less diversified in their human capital and personal wealth, focus on taking greater risks with the aim of attaining higher returns and once they pay the debt holders, the managers are able to share the remaining returns”, explains Fox & Marcus. Fox & Marcus explains that “an LBO therefore consolidates shareholders’ and management’s interests as a result of lack of power and control separation”. They explain that, “the economic perspective explains that in the absence of LBO, the management considers the share of profits given to shareholders to be a reduction in the level of assets under their control and they consider this as a reduction to their security, status and power”. “Managers are mandated to act as agents of the shareholders and are expected to utilize the decision-making authority that is delegated to them in a way that increases the wealth of shareholders and the board of directors is expected to oversee the management operations and to ensure that they operate in the best shareholders’ interests” (Fox &Marcus, 65). “Free cash flow theory also gives an explanation why firms undergo LBOs and the explanation for this is that firms usually aim at attaining a free cash flow for use in financing the projects that yield a positive cash flow” (Easterwood, Seth & Singer, 38). “A management buyout may also occur when managers want to save their position and this happens in case where there is a threat of a hostile takeover, which might arise due to management being inefficient in handling the assets of a company or due to differential information provided regarding a company”, explains fox & Marcus. They further state that, “LBOs limit the levels of engagement for management in wasteful spending, improves value by reducing management slack and increases flexibility while improving stakeholders’ commitment”. From the economists’ view, managers are agents of shareholders who mainly aim at maximizing their own returns and security as opposed to those of the shareholders (Fox & Marcus, 70). “Behaviorists hold that LBOs are redistributive, are usually faced with various ethical problems and that the premiums above the market price that are paid to the shareholders are as a result of tax advantages and insider information” (Fox & Marcus, 70). Fox & Marcus states that, “the asymmetry of information between the management and the shareholders create a conflict of interest between the responsibility of management to buy at highest price and their desire to buy at the lowest price”. “The management in the case of a management buyout is capable of manipulating information to understate the value of the firm to disguise the real value in the face of the shareholders and other members of the public and use this information to buy the company at a bargain price (Easterwood, Seth & Singer, 39). The influence of free cash flow and agency cost on firm’s performance Wang (408) uses Jensen’s definition, which defines free cash flow as the net cash flow of the operating cash flow less dividend payment, inventory cost and capital expenditure, a definition that is observed to lack accounting precision. “In the paper, free cash flow according to Lehn and Poulsen is defined as net operating income before depreciation expenses, less tax expenses, interest expenses, and stock dividends, scaled by net sales”. (Wang, 409). Wang states that, “Free cash flows are the discounted value of all the operating cash flows net of the needs of positive NPV projects”. He further insists that, “in addition to the accounting concept, free cash flows also represent idle cash flows at the discretion of management”. Wang stresses that “Free cash flow hypothesis implies that a higher level of free cash flows would lead to unnecessary waste and inefficiency by management and these result to agency cost, which is considered as a burden on the returns of the shareholders”. He continues to argue that, “the self-interest motive of management was an important factor leading to agency costs, and that this was especially obvious when stockholder’s and management’s interests were in conflict, and consequently stockholder’s interest was always dominated by those of the management”. “From the aspect of self-interest motive, management is likely to increase perquisite consumption and shirking behavior, which in turn leads to an increase in agency costs” resulting of this is a loss to the value of the firm (Wang, 410). Wang states that, “the hypothesis that defines the relationship between free cash flow and agency cost is tested using six variables”. He further states that “the null hypothesis H1: free cash flows have a positive impact on agency costs The results obtained evidenced the effects of free cash flow on agency cost”. “Free cash flow may act as a motivation to the management to increase consumption and this increases the agency cost incurred by the company”. “A negative relationship may also exist between free cash flow and agency costs since free cash flow results from the efficiency of management in its operations”, Wang argues. The negative relationship is also evidenced by the fact that availability of free cash flow increases the investing opportunities for the firm, which further increases the value of the firm. Free cash flow therefore has a positive impact on the performance of the company whereas agency costs have a negative effect on the performance of the company. Wang states that, “There is a positive relationship between the performance of a firm and free cash flow and the firm needs to have a viable investment in which it can invest the generated free cash flow and this will increase the performance of the firm from the use the free cash flow”. In the absence of viable investment opportunity, the firm will not be able to benefit from the positive relationship and Instead, the management misuses the available cash flow and the free cash flow ends up resulting to agency costs, further resulting to funds being invested in wrong and unprofitable investment and consequently inefficient allocation of resources” Wang argues. “Free cash flow also when in excessive levels, may result to negative effects on the profitability of the firm and to the valuation of the stock of the firm. (Yuangchih 417). “Agency costs have a negative relationship with the performance of the firm and occur in the case where there is separation between ownership and management and this is as a result of the inconsistence that exists between the management and shareholders”, (Kissan & Vernon, 97). It results to loss in the wealth of shareholders. This has a negative effect on the profitability of the firm by increasing the expenditure when dealing with the resulting agency problem. The variables used for measuring the effects of agency costs are ratio of floatation costs, net income volatility, advertising expense to sales ratio, operating expense to sales ratio, total assets turnover and administration expense to sales ratio. The operating expenses ratio and assets turnover ratio are efficient ways of showing the negative relationship that exists between agency costs and performance of a firm (Wang, 412). Conclusion In conclusion, free cash flow has been found to an effective measure of profitability of a firm. This is because a positive relationship has been evidenced to exist between the free cash flow and performance of a firm. The effectiveness of free cash flow for this measure has been observed to outweigh the other measures of performance. Increase in free cash flow increases the performance of a firm. The paper has considered the relationship between free cash flow and performance of firms in the capital intensive and non-capital intensive industry. It has also considered the leveraged buyout of firms as well as the relationship between free cash flow, agency costs and performance of firms. Works cited: Nunez, Karen. “free cash flow and performance predictability: an industry analysis”. International Journal of Business, Accounting, & Finance, 8. 2 (2014): 120-135 Fox, Isaac & Marcus Alfred. “The causes and consequences of leveraged management buyouts”. Academy of Management Review, 17.1 (2015):62-85 Easterwood John, Seth Anju, Singer Ronald. “The Impact of Leveraged Buyouts on Strategic Direction”. California Management Review, 32.1 (2015): 30-43 Yuangchih, Wang. “The impacts of free cash flows and agency costs on firm performance”. Journal of Service Science and Management, 4 (2010): 408- 418 Bowen, Robert, Burgstahler, David & Daley, Lane. “Evidence on the Relationships between Earnings and Various Measures of Cash Flow”. The Accounting Review, 61.4 (2013): 713-725 Kissan, Joseph & Vernon, Richardson. Free Cash Flow, Agency Costs, and the Affordability Method of Advertising Budgeting. Journal of Marketing, 66.1 (2002): 94-107. Read More