Review of Accounting Studies

, Volume 11, Issue 2–3, pp 159–189 | Cite as

Over-investment of free cash flow



This paper examines the extent of firm level over-investment of free cash flow. Using an accounting-based framework to measure over-investment and free cash flow, I find evidence that, consistent with agency cost explanations, over-investment is concentrated in firms with the highest levels of free cash flow. Further tests examine whether firms’ governance structures are associated with over-investment of free cash flow. The evidence suggests that certain governance structures, such as the presence of activist shareholders, appear to mitigate over-investment.


Free cash flow Over-investment Agency costs 

JEL Classification

G3 M4 



This paper is based on my dissertation at the University of Michigan. I would like to thank members of my dissertation committee: Richard Sloan (Chair), Jerry Davis, Patricia Dechow, Doug Skinner and Matthew Shapiro. I appreciate helpful comments from workshop participants at Boston College, University of California, Berkeley, University of Chicago, Columbia University, Harvard University, MIT, New York University, Northwestern University, University of Pennsylvania, University of Rochester and Stanford University, Mark Bradshaw, Dan Collins, John Core, Julie Cotter, Ilia Dichev, Jef Doyle, Hulya Eraslan, Ray Fisman, Ted Goodman, Raffi Indjejikian, Irene Kim, David Larcker, Charles Lee (editor), Russell Lundholm, Andrew Metrick, David Musto, Venky Nagar, Stephen Penman, Abbie Smith, Gary Solon, Steve Taylor, Irem Tuna, Ross Watts, Peter Wysocki, Stephen Young, an anonymous referee and conference participants at the 2005 Review of Accounting Studies Conference, especially those of Daniel Bergstresser. I would like to recognize financial support from the Paton Scholarship Fund, the Deloitte & Touche Foundation, the Arthur Andersen Foundation and the Michael J. Barrett Dissertation Award from the Institute of Internal Auditors.


  1. Allen, F., & Michaely, R. (2003) Payout policy. In North-Holland handbook of economics edited by George Constantinides, Milton Harris, and Rene Stulz.Google Scholar
  2. Alti, A. (2003). How sensitive is investment expenditure to cash flow when financing is frictionless? Journal of Finance, 53, 707–722.CrossRefGoogle Scholar
  3. Barro, R. (1990). The stock market and investment. Review of Financial Studies, 3, 115–131.CrossRefGoogle Scholar
  4. Bates, T. W. (2005). Asset sales, investment opportunities, and the use of proceeds. Journal of Finance, 60, 105–135.CrossRefGoogle Scholar
  5. Berger, P. G., & Hann, R. (2003). The impact of SFAS 131 on Information and Monitoring. Journal of Accounting Research, 41, 163–223.CrossRefGoogle Scholar
  6. Blanchard, O. J., Lopez-de-Silanes, F., & Shleifer, A. (1994). What do firms do with cash windfalls? Journal of Financial Economics, 36, 337–360.CrossRefGoogle Scholar
  7. Brown, L., & Caylor, M. (2004). Corporate Governance and Firm Performance. Working paper, Georgia State University.Google Scholar
  8. Bushman, R. M., Piotroski, J. D., & Smith, A. J. (2005). Capital allocation and timely recognition of economic losses: International evidence. Working paper, University of Chicago.Google Scholar
  9. DeAngelo, H., DeAngelo, L., & Stulz, R. (2004). Dividend Policy, Agency Costs and Earned Equity. Working paper, University of Southern California.Google Scholar
  10. Dechow, P. M., Hutton, A. P., & Sloan, R. G. (1999). An empirical assessment of the residual income valuation model. Journal of Accounting and Economics, 26, 1–34.CrossRefGoogle Scholar
  11. Dechow, P. M., Richardson, S. A., & Sloan, R. G. (2005). The Persistence and Pricing of the Cash Component of Earnings. Working paper, University of Michigan and University of Pennsylvania.Google Scholar
  12. Dey, A. (2005). Corporate governance and financial reporting credibility. Working paper, Northwestern University.Google Scholar
  13. Fairfield, P. M. (1994). P/E, P/B and the present value of future dividends. Financial Analysis Journal, July–Aug, 23–31CrossRefGoogle Scholar
  14. Fairfield, P. M., Whisenant, J. S., & Yohn, T. L. (2003). Accrued earnings and growth: Implications for future profitability and market mispricing. Accounting Review, 78, 353–371.Google Scholar
  15. Fama, E. F., & French, K. R. (1997). Industry costs of equity. Journal of Financial Economics, 43, 153–194CrossRefGoogle Scholar
  16. Fama, E. F., & Macbeth, J. D. (1973). Risk, return and equilibrium—empirical tests. The Journal of Political Economy, 81, 607–636CrossRefGoogle Scholar
  17. Fazzari, S. M., Hubbard, R. G., & Petersen, B. C. (1988). Financing constraints on corporate investment. Brookings Papers on Economic Activity, 141–195.Google Scholar
  18. Fazzari, S. M., & Petersen, B. C. (1993). Working capital and fixed investment: New evidence on financing constraints. RAND Journal of Economics, 24, 328–342.CrossRefGoogle Scholar
  19. Feltham, G. A., & Ohlson, J. A. (1996). Uncertainty resolution and the theory of depreciation measurement. Journal of Accounting Research, 34, 209–234.CrossRefGoogle Scholar
  20. Gompers, P. A., Ishii, J. L., & Metrick, A. (2003). Corporate Governance and Equity Prices. Quarterly Journal of Economics, 118, 107–155.CrossRefGoogle Scholar
  21. Goodman, T. H. (2005). How do contracts adapt to an increase in free cash flow? Working paper, University of Pennsylvania.Google Scholar
  22. Harford, J. (1999). Corporate cash reserves and acquisitions. Journal of Finance, 54, 1969–1997.CrossRefGoogle Scholar
  23. Hoshi, T., Kashyap, A., & Scharfstein, D. (1991). Corporate structure, liquidity and investment: Evidence from Japanese industrial groups. Quarterly Journal of Economics, 106, 33–60.CrossRefGoogle Scholar
  24. Hubbard, R. G. (1998). Capital-market imperfections and investment. Journal of Economic Literature, 36, 193–225.Google Scholar
  25. Iman, R. L., & Conover, W. J. (1979). The use of rank transform in regression. Technometrics, 21, 499–509.CrossRefGoogle Scholar
  26. Jensen, M. C. (1986). Agency costs and free cash flow, corporate finance and takeovers. American Economic Review, 76, 659–665.Google Scholar
  27. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3, 305–360.CrossRefGoogle Scholar
  28. Kaplan, S. N., & Zingales, L. (1997). Do investment-cash flow sensitivities provide useful measures of financing constraints? Quarterly Journal of Economics, 112, 169–215CrossRefGoogle Scholar
  29. Kaplan, S. N., & Zingales, L. (2000). Investment-cash flow sensitivities are not valid measures of financing constraints. Quarterly Journal of Economics, 115, 707–712.CrossRefGoogle Scholar
  30. Lamont, O. (1997). Cash flow and investment: Evidence from internal capital markets. Journal of Finance, 52, 83–109.CrossRefGoogle Scholar
  31. Lamont, O. (2000). Investment plans and stock returns. Journal of Finance, 55, 2719–2748.CrossRefGoogle Scholar
  32. Lang, L. H. P., Stulz, R. M., & Walkling, R. A. (1991). A test of the free cash flow hypothesis: The case of bidder returns. Journal of Financial Economics, 29, 315–335CrossRefGoogle Scholar
  33. Larcker, D. F., Richardson, S. A. & Tuna, A. I. (2005). How important is corporate governance? Working paper, University of Pennsylvania.Google Scholar
  34. Li, D. (2004). The implications of capital investments for future profitability and stock returns—an overinvestment perspective. Working paper, University of California, Berkeley.Google Scholar
  35. Modigliani, F., & Miller, M. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48, 261–297.Google Scholar
  36. Morck, R., Shleifer, A., & Vishny, R. W. (1990). Do managerial objectives drive bad acquisitions? Journal of Finance, 45, 31–48.CrossRefGoogle Scholar
  37. Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5, 147–175.CrossRefGoogle Scholar
  38. Myers, S. C., & Majluf, N. (1984). Corporate financing and investment decisions when firms have investment information that investors do not have. Journal of Financial Economics, 13, 187–220.CrossRefGoogle Scholar
  39. Ohlson, J. A. (1995). Earnings, book values and dividends in security valuation. Contemporary Accounting Research, 11, 661–687.CrossRefGoogle Scholar
  40. Opler, T., Pinkowitz, L., Stulz, R., & Williamson, R. (1999). The determinants and implications of corporate cash holdings. Journal of Financial Economics, 52, 3–46.CrossRefGoogle Scholar
  41. Opler, T., Pinkowitz, L., Stulz, R., & Williamson, R. (2001). Corporate cash holdings. Journal of Applied Corporate Finance, 14, 55–66.CrossRefGoogle Scholar
  42. Opler, T., & Titman, S. (1993). The determinants of leveraged buyout activity: Free cash flow vs. financial distress costs. The Journal of Finance, 48, 1985–1999.CrossRefGoogle Scholar
  43. Penman, S. H. (1991). An evaluation of accounting rate of return. Journal of Accounting, Auditing and Finance Spring, 6, 233–255Google Scholar
  44. Penman, S. H. (1996). The articulation of price-earnings ratios and market-to-book ratios and the evaluation of growth. Journal of Accounting Research, 34, 235–259.CrossRefGoogle Scholar
  45. Rogers, W. (1993). Regression standard errors in clustered samples. Stata technical bulletin reprints (vol. 3, pp. 83–94). College Station, Texas: Stata Press.Google Scholar
  46. Shleifer, A., & Vishny, R. W. (1997). A survey of corporate governance. Journal of Finance, 52(2), 737–783.CrossRefGoogle Scholar
  47. Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71, 289–315.Google Scholar
  48. Strong, J. S., & Meyer, J. R. (1990). Sustaining Investment, discretionary investment, and valuation: A residual funds study of the paper industry. In R. G. Hubbard (ed.) Asymmetric information, corporate finance, and investment (pp. 127–148). Chicago, IL: University of Chicago Press.Google Scholar
  49. Stulz, R. M. (1990). Managerial discretion and optimal financing policies. Journal of Financial Economics, 26, 3–27.CrossRefGoogle Scholar
  50. Titman, S., Wei, K. C. J., & Xie, F. (2004). Capital investments and stock returns. Journal of Financial and Quantitative Analysis, 39, 677–700.CrossRefGoogle Scholar
  51. Wang, X. (2003). Capital allocation and accounting information properties. Working paper, Emory University.Google Scholar
  52. White, H. (1980). A Heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity. Econometrica, 48, 817–838.CrossRefGoogle Scholar
  53. Whited, T. (1992). Debt, liquidity constraints and corporate investment: Evidence from panel data. Journal of Finance, 47, 1425–1460.CrossRefGoogle Scholar
  54. Wilcox, J. (1984). The P/B-ROE valuation model. Financial Analysts Journal, Jan–Feb, 58–66.CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC 2006

Authors and Affiliations

  1. 1.Wharton SchoolUniversity of PennsylvaniaPhiladelphiaUSA

Personalised recommendations