The Impacts of Free Cash Flows and Agency Costs on Firm Performance

George Yungchih Wang

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DOI: 10.4236/jssm.2010.34047                

Abstract

This paper investigates how free cash flow (FCF) is associated with agency costs (AC), and how FCF and AC influence firm performance. The research purpose is therefore threefold. Specifically, the study is to explore the impact of FCF on AC, to re-examine the free cash flow hypothesis, and to test the agency theory based on the empirical data from Taiwan publicly-listed companies. The study uses the variable of standard free cash flow to measure FCF and six proxy variables to measure AC. It is found that FCF has a significant impact on AC with two contrary effects. On one hand, FCF could incur AC due to perquisite consumption and shirking behavior; on the other hand, the generation of FCF, resulting from internal operating efficiency, could lead to better firm performance. Excluding insignificant proxy variables of AC and including only total asset turnover and operating expense ratio as sufficient AC measures, the study finds evidence to support the agency theory, meaning AC has a significantly negative impact on firm performance and stock return. In contrast, the study finds a significantly positive relation between FCF and firm performance measures, indicating lack of evidence supporting the free cash flow hypothesis. The study provides a better understanding of the association among FCF, AC, and firm performance.

Keywords

Agency Theory, Free Cash Flow Hypothesis, Free Cash Flows, Agency Costs, Firm Performance

Conflicts of Interest

The authors declare no conflicts of interest.

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