Over- and under-investment of free cash flow – Recent evidence from US-based public companies

Abstract

Purpose of the study

The purpose of the thesis is to study the implications from the free cash flow hypothesis, first defined by Jensen (1986), by investigating the relation between firm-level abnormal investment and availability of free cash flow. The study aims to first classify abnormal investment to two categories, over- and under-investment, by using an accounting-based framework developed by Richardson (2006). Secondly, by defining overinvestment as an investment in NPV negative projects and underinvestment as the act of declining NPV positive projects, the study relates these two categories of abnormal investment to firm’s free cash flow. The thesis extends and validates previous research from two aspects. Firstly, it provides an updated analysis on the free cash flow problem in the US with a fresh set of data. Secondly, instead of solely focusing on overinvestment, the study extends the scope of investigation by including the act of underinvestment as one of the thesis’s primary points of interest.

Data

The data of this study consists of 2,458 US-based public firms with 9,394 firm-year-observations over the fiscal years 2008-2014. The investment expectation model analyses the level of new investment of the firm as the dependent variable against lagged control variables for firm’s growth opportunities, leverage, cash level, size, firm age, stock returns and prior year new investment. Additionally, year and industry dummies are included in the regression. The residuals from this regression, corresponding to both types of abnormal investment, are then related to the firm’s level of free cash flow to study the relation between firm’s positive (negative) free cash flow and over-investment (under-investment). All data is gathered from COMPUSTAT database.

Results

The results of the thesis indicate that over- and underinvestment continues to be a persistent issue affecting the operations of non-financial public US companies. I find on a reasonable incremental significance level that overinvestment (underinvestment) is concentrated in firms with positive (negative) free cash flow. This confirms the results of previous research. The outcome of this study validates the results from previous research and sheds light on the present relation between US-based firms’ level of free cash and investment activities. The results overall support the agency cost theory and the free cash flow problem.