Agency Cost

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

Michael C. Jensen
Harvard Business School
MJensen@hbs.edu

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 attention.1 Payouts to shareholders reduce the resources under managers’ control, thereby reducing managers’ power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital (see Easterbrook, 1984, and Rozeff, 1982). Financing projects internally avoids this monitoring and the possibility the funds will be unavailable or available only at high explicit prices.

Managers have incentives to cause their firms to grow beyond the optimal size. Growth increases managers’ power by increasing the resources under their control. It is also associated with increases in managers’ compensation, because changes in compensation are positively related to the growth in sales (see Murphy, 1985). The 1

Gordon Donaldson (1984) in his study of 12 large Fortune 500 firms concludes the managers of these firms were not driven by the maximization of the value of the firm, but rather by the maximization of “corporate wealth,” defined as “the aggregate purchasing power available to management for strategic purposes during any given planning period” (p. 3). “In practical terms it is cash, credit, and other corporate purchasing power by which management commands goods and services” (p. 22). * La Claire Professor of Finance and Business Administration and Director of the Managerial Economics Research Center, University of Rochester Graduate School of Management, Rochester, NY 14627, and Professor of Business Administration, Harvard Business School. This research is supported by the Division of Research of the Harvard Business School, and the Managerial Research Center, University of Rochester. I have benefited from discussions with George Baker, Gordon Donaldson, Allen Jacobs, Jay Light, Clifford Smith, Wolf Weinhold, and especially Armen Alchian and Richard Ruback.

Michael C. Jensen

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1986

tendency of firms to reward middle managers through promotion rather than year-to-year bonuses also creates a strong...
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