Agency Cost

Agency Costs of Free Cash Flow,
Corporate Finance, and Takeovers

Michael C. Jensen
Harvard Business School
[e-mail]

Abstract
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. These conflicts are especially severe in firms with large free cash flows—more cash than profitable investment opportunities.
The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why “diversification” programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidationmotivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.
Keywords: Dividend policy, Corporate Payout Policy, Optimal Capital Structure, Optimal Debt,
Reivestment Policy, Overinvestment

© Copyright 1986. Michael C. Jensen. All rights reserved.
American Economic Review, May 1986, Vol. 76, No. 2, pp. 323-329.

You may redistribute this document freely, but please do not post the electronic file on the web. I welcome web links to this document at http://papers.ssrn.com/abstract=99580. I revise my papers regularly, and providing a link to the original ensures that readers will receive the most recent version. Thank you, Michael C. Jensen

Agency Costs of Free Cash Flow,
Corporate Finance, and Takeovers

Michael C. Jensen*
American Economic Review, May 1986, Vol. 76, No. 2, pp. 323-329.

Corporate managers are the agents of shareholders, a relationship fraught with conflicting interests. Agency theory, the analysis of such conflicts, is now a major part of the economics literature. The payout of cash to shareholders creates major conflicts that have received little

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