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Summary Agency Costs of Free Cash Flows - Jensen 1986 $3.25   Add to cart

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Summary Agency Costs of Free Cash Flows - Jensen 1986

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Summary of the paper of Jensen in 1986

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  • November 4, 2016
  • 2
  • 2016/2017
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5  reviews

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By: maggiebai95 • 6 year ago

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By: cogurizvi • 6 year ago

Could expand more and use proper grammar.

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By: suleman91 • 6 year ago

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By: amelel • 7 year ago

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By: jw4277 • 7 year ago

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Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers
MICHAEL C. JENSEN


In this paper, Jensen highlights the existing conflicts of interest between shareholders
and the corporate managers of a company. Indeed the payouts of dividends to the
shareholders reduce the amount of cash under managers’ control which leads to a loss of
managers’ power. This is called the “Agency Theory”. Jensen is especially interested in
companies with Free Cash Flows (FCF). Managers have incentives to grow their company,
by investing these FCF, into the company because their compensation is linked with the size
of the company. Besides, this growth policy also facilitates the promotions inside the
company. Such a situation imply that it is needed to find some ways to motivate managers to
give back these FCF to the investors. The theory developed here describes:


● The benefits of debt in reducing agency costs of free cash flows
● How debt can substitute for dividends
● Why "diversification" programs are more likely to generate losses than takeovers or
expansion in the same line of business or liquidation-motivated takeovers
● Why the factors generating takeover activity in such diverse activities as broadcasting
and tobacco are similar to those in oil
● Why bidders and some targets tend to perform abnormally well prior to takeover


Firstly, Jensen is supposing that one of the good way to reduce these FCF is to finance
itself through indebtedness. According to Jensen, it is more efficient than distributing
dividends or repurchasing stock. These effects on the efficiency of the organization are called
the “Control Hypothesis”. In that case, the managers give the right to the shareholder
recipients of the debt to take the company into bankruptcy court if the debt is not settle. In
this way, debt creation reduces the amount of cash available for spending by managers and at
the same time reduces the agency costs of FCF. Furthermore, it is important to highlight that
this Control Hypothesis does not always imply positive control effects. Indeed the control
function is more important in companies that have low growth prospects but that generates
high FCF. As a conclusion, issuing debt is a promise to pay out the a certain dividend to the
investors in the future. While promising to distribute normal dividends can be reversed. This
explains how debt can substitute for dividends.

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