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Free cash flow

Free cash flow (FCF) is a key financial metric representing the cash a company generates from its operations after accounting for capital expenditures necessary to maintain or expand its asset base, providing a measure of the funds available for discretionary uses such as dividends, debt repayment, or reinvestment.^[1] This metric is derived primarily from a company's cash flow statement and highlights the actual liquidity produced by core business activities beyond non-cash accounting figures like net income.^[2] FCF can be calculated in multiple ways, with a common formula being operating cash flow minus capital expenditures (CapEx), or alternatively, earnings before interest and taxes (EBIT) adjusted for non-cash charges (such as depreciation), taxes, changes in working capital, and CapEx.^[1] There are two primary variants: free cash flow to the firm (FCFF), which measures cash available to all capital providers (debt and equity holders) after operating expenses, taxes, and reinvestments, calculated as net income + non-cash charges + interest expense (1 - tax rate) - fixed capital investment - working capital investment; and free cash flow to equity (FCFE), which focuses on cash available to common shareholders after debt payments, derived as net income + non-cash charges - fixed capital investment - working capital investment + net borrowing.^[2] These distinctions allow for tailored analysis depending on whether valuing the entire firm or equity specifically.^[2] In financial analysis and valuation, FCF is crucial for assessing a company's true profitability, operational efficiency, and ability to generate returns for investors, often serving as the basis for discounted cash flow (DCF) models where future FCF projections are discounted at the weighted average cost of capital (WACC) for FCFF or the cost of equity for FCFE to estimate intrinsic value.^[2] It gained prominence through Michael Jensen's 1986 agency theory, which posits that excess FCF can lead to agency costs if managers pursue value-destroying investments rather than returning cash to shareholders, influencing corporate finance practices like leveraged buyouts and dividend policies.^[3] Despite its utility, FCF calculations can vary due to differences in accounting treatments for depreciation and CapEx, requiring careful interpretation.^[1]

Fundamentals

Definition

Free cash flow (FCF) represents the cash a company generates from its core business operations after deducting the capital expenditures required to maintain or expand its asset base, providing a measure of the actual liquidity available for discretionary uses such as debt repayment, dividends, or reinvestment.^[4] This metric emphasizes cash generation over accounting profits, highlighting the funds left after sustaining the business's productive capacity.^[5] There are two primary variants of FCF: unlevered free cash flow (FCFF), which is available to all capital providers including debt and equity holders, calculated before interest and debt payments; and levered free cash flow (FCFE), which is the residual cash available specifically to equity holders after accounting for debt obligations such as interest and principal repayments.^[6] The distinction is crucial because FCFF reflects the firm's overall operational health independent of its financing structure, while FCFE focuses on the returns to shareholders.^[7] The concept of free cash flow was first coined in 1972 by financial analyst Joel Stern to overcome the shortcomings of accrual-based accounting metrics like earnings, which can be manipulated and do not directly indicate cash availability.^[8] Stern, a pioneer in value-based management, developed FCF as part of broader efforts to align corporate performance with economic value creation.^[9] At its core, FCF comprises operating cash flow—the cash generated from day-to-day business activities—subtracted by capital expenditures (CapEx), which include investments in property, plant, equipment, and other long-term assets necessary for ongoing operations.^[5] This subtraction ensures the metric captures only the sustainable cash surplus beyond what is needed to preserve or grow the company's capital stock.^[4]

Importance in Financial Analysis

Free cash flow (FCF) is considered superior to accrual-based metrics like net income in financial analysis because it provides a clearer picture of the actual cash generated by a company's operations after accounting for necessary capital expenditures, thereby reflecting the true availability of funds for strategic uses such as paying dividends, repaying debt, or reinvesting in growth initiatives.^[10] Unlike net income, which can be influenced by non-cash accounting adjustments and estimates, FCF emphasizes liquidity and operational cash generation, making it a more reliable indicator of a company's financial flexibility and sustainability.^[10] This focus on cash reality helps analysts avoid distortions from accrual accounting practices that may overstate or understate performance.^[11] Investors particularly value FCF for evaluating the sustainability of dividend payments and a company's potential for long-term growth, as it demonstrates the cash buffer available to support shareholder returns without compromising operational needs.^[10] Strong and consistent FCF signals that a firm can fund expansions, acquisitions, or share buybacks internally, reducing reliance on external financing and appealing to value-oriented investors seeking undervalued opportunities with robust cash-generating capabilities.^[12] For instance, companies with healthy FCF are often prioritized in equity strategies because they exhibit resilience during economic downturns and the ability to compound value over time.^[13] Credit analysts rely on FCF to assess a company's liquidity and solvency, as it measures the cash available to service debt obligations and maintain financial stability amid varying business cycles. Positive FCF indicates sufficient internal resources to cover interest payments and principal repayments, enhancing a firm's creditworthiness and lowering default risk, while negative FCF may highlight vulnerabilities such as excessive capital spending or operational inefficiencies that could strain solvency.^[10] In credit rating methodologies, FCF is a key factor in evaluating cash flow adequacy and the degree of financial cushion against leverage, helping to determine a borrower's ability to withstand stress scenarios.^[14] For example, a company generating positive FCF consistently demonstrates operational efficiency by producing more cash than required for maintaining its asset base, allowing it to pursue value-creating opportunities without diluting equity or increasing debt loads.^[11] Conversely, persistent negative FCF might signal overinvestment in unprofitable projects or underlying distress, prompting analysts to scrutinize management strategies and potential restructuring needs to restore cash generation.^[10]

Calculation Approaches

Primary Formula

The primary formula for free cash flow (FCF) is derived directly from the statement of cash flows and is expressed as:

\text{FCF} = \text{Operating Cash Flow (OCF)} - \text{Capital Expenditures (CapEx)}

This approach represents the cash generated by a company's core operations after accounting for investments required to maintain or expand its asset base.^[1]^[10] Operating cash flow, the starting point, captures the net cash provided by or used in a company's operating activities, as reported in the statement of cash flows under U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).^[15] It is typically calculated using the indirect method, beginning with net income from the income statement and adjusting for non-cash expenses—such as depreciation and amortization—which are added back because they reduce net income without affecting cash—and for changes in working capital accounts, such as increases in accounts receivable (subtracted) or decreases in accounts payable (added).^[16]^[17] For example, if a company reports net income of $100 million, adds back $20 million in depreciation, and subtracts $10 million for an increase in inventory, the resulting OCF would be $110 million.^[18] Capital expenditures refer to the cash outflows for acquiring, upgrading, or maintaining long-term physical assets, primarily reported under investing activities in the cash flow statement as purchases of property, plant, and equipment (PP&E).^[19] CapEx is calculated on a net basis, subtracting any proceeds from the sale of such assets to reflect the true reinvestment cost.^[20] These expenditures are essential for sustaining operational capacity but are deducted from OCF to isolate discretionary cash available for other uses.^[21] To derive FCF step-by-step from the statement of cash flows: (1) Identify the net cash from operating activities line, which already incorporates the adjustments to net income described above; (2) Locate the investing activities section and extract the net cash outflow for PP&E (purchases minus sales proceeds), excluding other investing items like acquisitions or securities purchases that are not core to ongoing operations; (3) Subtract this net CapEx amount from OCF to arrive at FCF.^[1]^[10] This method ensures FCF reflects sustainable cash generation without reliance on financing or non-operational investing.^[22] Analysts often make adjustments to this primary calculation to exclude non-recurring items for a normalized view, such as adding back proceeds from one-time asset sales included in investing activities or removing unusual operating cash inflows like litigation settlements.^[23]^[24] These adjustments prevent distortions from infrequent events, focusing on recurring cash flows for valuation or performance assessment.^[1]

Alternative Formulas

One common alternative to direct cash flow statement derivation of free cash flow involves reconstructing it from income statement and balance sheet items, providing flexibility for financial modeling and forecasting when historical cash flow data is limited or unavailable. This approach starts with earnings before interest and taxes (EBIT) to compute unlevered free cash flow (FCFF), which represents cash available to all capital providers before debt-related payments. The formula is:

\text{FCFF} = \text{EBIT} \times (1 - \text{[Tax Rate](/page/Tax_rate)}) + \text{[Depreciation \& Amortization](/page/Depreciation)} - \Delta \text{[Working Capital](/page/Working_capital)} - \text{CapEx}

Here, EBIT is adjusted for taxes to reflect after-tax operating earnings, non-cash charges like depreciation and amortization are added back, changes in working capital account for operational cash needs, and capital expenditures (CapEx) subtract reinvestments in fixed assets.^[1] This unlevered variant is particularly useful in discounted cash flow (DCF) valuations of the entire firm, as it ignores financing structure and focuses on operational cash generation. For analyses centered on shareholders, a levered free cash flow to equity (FCFE) variant adjusts from net income, incorporating debt effects to isolate cash distributable after all obligations. The formula is:

\text{FCFE} = \text{[Net Income](/page/Net_income)} + \text{Non-Cash Charges} - \Delta \text{[Working Capital](/page/Working_capital)} - \text{CapEx} + \text{Net Borrowing}

Non-cash charges primarily include depreciation and amortization, while net borrowing adds the net proceeds from new debt minus principal repayments. This method is applied in equity-specific valuations, such as estimating intrinsic stock value or assessing dividend capacity, since it reflects post-debt-service cash flows.^[25] The choice between these formulas hinges on context: the income statement-based unlevered approach suits scenarios like pro forma projections where cash flow statements are absent, enabling analysts to build models from projected earnings and balance sheet changes; the equity variant, by contrast, is tailored for shareholder-oriented evaluations, adjusting explicitly for interest tax shields and leverage impacts. In levered contexts, interest expenses are deducted pre-tax in net income but benefit from tax deductibility, whereas unlevered FCFF normalizes for taxes on operating income without interest adjustments, ensuring consistency in firm-wide assessments.^[27]^[28]

Comparisons with Other Metrics

Versus Net Income

Net income represents an accrual-based measure of profitability, calculated as revenues minus all expenses, including non-cash items such as depreciation and amortization, under generally accepted accounting principles (GAAP). In contrast, free cash flow (FCF) provides a cash-based perspective by starting from net income and adjusting for actual cash inflows and outflows to reflect the true liquidity generated by operations after necessary investments.^[29] This fundamental difference arises because net income recognizes revenues and expenses when earned or incurred, regardless of cash movement, while FCF focuses on cash availability for discretionary use.^[30] Key divergences between the two metrics include the treatment of non-cash expenses and capital requirements. For instance, non-cash charges like depreciation are added back to net income in FCF calculations since they do not involve actual cash outflows, providing a clearer view of operational cash generation.^[1] Conversely, FCF subtracts changes in working capital—such as increases in accounts receivable or inventory that tie up cash—and capital expenditures (CapEx) for property, plant, and equipment, which net income entirely ignores as they are capitalized and depreciated over time rather than expensed immediately.^[29] These adjustments highlight how net income can overstate financial health by excluding the cash demands of day-to-day operations and growth investments.^[31] A representative example illustrates this gap: Amazon.com Inc. reported positive net income in several years, such as $33.4 billion in 2021, yet generated negative FCF of -$9.1 billion due to substantial CapEx in fulfillment centers and technology infrastructure exceeding its operating cash flows.^[32] This scenario demonstrates how a company can appear profitable on an accrual basis while facing cash constraints from reinvestments essential for expansion.^[1] The implications of these differences are significant for financial analysis. Net income is susceptible to manipulation through accounting choices, such as revenue recognition timing or expense deferrals, which can inflate reported profits without corresponding cash inflows.^[33] In comparison, FCF offers a more reliable indicator of a company's ability to generate cash for dividends, debt repayment, or shareholder returns, revealing underlying operational sustainability beyond accounting conventions.^[31]

Versus Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

EBITDA, or earnings before interest, taxes, depreciation, and amortization, serves as a common proxy for a company's operating cash flow by adding back non-cash expenses like depreciation and amortization to earnings before interest and taxes (EBIT).^[34] This metric provides a quick view of core operational profitability but excludes critical cash outflows such as capital expenditures (CapEx), changes in working capital, and actual tax payments.^[35] In contrast, free cash flow (FCF) starts from operating cash flow and subtracts CapEx, while also accounting for working capital fluctuations and taxes, offering a more accurate measure of discretionary cash available after maintaining or expanding the business.^[36] The primary gaps between EBITDA and FCF arise because EBITDA does not deduct investments in fixed assets or adjustments for short-term operational needs, often leading to an overestimation of a company's cash-generating ability and sustainability.^[34] For instance, in capital-intensive industries, high CapEx can significantly reduce FCF below EBITDA levels, masking potential liquidity strains.^[35] This discrepancy is particularly evident in high-growth tech firms like Amazon, where substantial investments in infrastructure and R&D during expansion phases have resulted in positive EBITDA alongside negative or low FCF, highlighting the need for reinvestment over immediate cash distribution.^[37] Conversely, capital-light businesses, such as software-as-a-service providers with minimal CapEx, may exhibit closer alignment between the two metrics.^[35] While EBITDA remains useful as a simple, standardized benchmark for comparing operational performance across firms—especially in mature, low-CapEx sectors—it falls short as a standalone indicator for assessing true cash availability or long-term viability.^[34] Analysts often pair it with FCF to gain a fuller picture, avoiding overreliance on its optimistic portrayal of cash flows.^[36]

Practical Applications

In Business Valuation

Free cash flow serves as a foundational metric in business valuation, most prominently within discounted cash flow (DCF) models, where it enables the estimation of a company's intrinsic value by projecting and discounting future cash flows available to investors.^[2] In these models, unlevered free cash flow to the firm (FCFF) is discounted at the weighted average cost of capital (WACC) to derive enterprise value, reflecting cash generated for all capital providers, while levered free cash flow to equity (FCFE) is discounted using the cost of equity to determine equity value directly.^[38] The DCF valuation process typically involves forecasting free cash flows over an explicit period of 5 to 10 years, drawing on assumptions about revenue growth, operating margins, tax rates, and required reinvestments in working capital and capital expenditures.^[39] To account for cash flows beyond this horizon, a terminal value is appended, commonly via the Gordon growth model assuming perpetual growth:

TV = \frac{FCF_{n+1}}{r - g}

where FCF_{n+1} represents the expected free cash flow in the year following the forecast period, r is the discount rate (WACC for FCFF or cost of equity for FCFE), and g is the long-term growth rate, typically set below nominal GDP growth to ensure conservatism.^[38] The present values of the projected free cash flows and terminal value are then summed and, for enterprise valuation, adjusted by subtracting net debt to yield equity value.^[40] Adjustments to the standard DCF approach are often necessary for companies in high-growth phases or cyclical industries, where multi-stage models incorporate varying growth rates or normalized earnings cycles to better reflect economic realities.^[2] Complementing DCF, free cash flow multiples such as enterprise value to free cash flow (EV/FCF) provide a relative valuation benchmark by comparing a target company to peers, offering quick insights into over- or undervaluation.^[38] The application of free cash flow in valuation was popularized in the 1980s amid the surge in leveraged buyouts (LBOs), where it became critical for evaluating acquisition targets' ability to generate sufficient cash to service high levels of debt, thereby mitigating agency costs associated with excess cash holdings.^[3]

In Corporate Decision-Making

In corporate decision-making, free cash flow (FCF) serves as a critical metric for management to allocate resources effectively, balancing short-term financial obligations with long-term growth opportunities. Companies typically direct positive FCF toward dividends, share buybacks, debt reduction, or reinvestment in new projects that are expected to generate net present value (NPV)-positive returns. For instance, allocating FCF to debt reduction strengthens the balance sheet by lowering interest expenses and improving credit ratings, while share buybacks can signal confidence in future performance and enhance earnings per share.^[41] This allocation process is guided by the principle that FCF represents discretionary cash available after essential operating and capital needs are met, enabling executives to prioritize initiatives that maximize shareholder value without compromising operational stability.^[42] FCF also informs performance evaluation through metrics like FCF yield, which measures the cash generated relative to enterprise value and acts as a benchmark for return on investment (ROI) in strategic initiatives. A high FCF yield indicates efficient capital use, helping managers assess whether ongoing projects are delivering adequate returns compared to alternatives such as returning cash to shareholders. Additionally, comparisons with return on invested capital (ROIC) ensure value creation, as ROIC evaluates the profitability of capital deployed, and sustained FCF growth above the weighted average cost of capital (WACC) confirms that investments are accretive. For example, firms aim for ROIC exceeding WACC to validate decisions on capital expenditures, with FCF providing the tangible cash flow evidence of such efficiency.^[43]^[42] Strategically, the use of FCF varies by company lifecycle stage: mature firms with stable cash flows often return excess FCF to shareholders via dividends or buybacks to optimize capital structure, as seen in industries like consumer goods where predictable revenues support consistent payouts. In contrast, growth-oriented companies reinvest FCF into capital expenditures (CapEx) for expansion, such as R&D or acquisitions, to fuel scaling while monitoring for diminishing returns. This approach aligns resource deployment with competitive positioning, ensuring reinvestments yield higher future FCF.^[41] Management routinely monitors FCF trends to refine budgeting and forecasting, using historical patterns and scenario analysis to predict cash availability and adjust operational plans. Declining FCF trends may prompt cost controls or divestitures, while upward trajectories support aggressive forecasting for new investments, enhancing overall financial resilience and decision accuracy.^[44]^[45]

Limitations and Challenges

Issues with Capital Expenditures

Capital expenditures (CapEx) in free cash flow (FCF) calculations are classified into maintenance CapEx, which covers replacements and upkeep to sustain existing operations, and growth CapEx, which funds expansions or new assets to increase future cash flows.^[46]^[47] This distinction is crucial because standard FCF subtracts total CapEx from cash flow from operations, but misallocation—such as treating growth spending as maintenance or excluding it—can understate total deductions, thereby inflating reported FCF and misleading investors about available cash.^[48]^[49] Companies rarely disclose the breakdown explicitly, leading to estimation challenges where depreciation is often used as a proxy for maintenance CapEx, potentially over- or understating true requirements if asset lives or obsolescence are misjudged.^[46]^[50] Forecasting CapEx introduces significant subjectivity, as historical levels may not reliably predict future needs, particularly in dynamic industries. For instance, technology firms often require minimal CapEx due to scalable digital assets, while manufacturing entities face higher ongoing investments in physical infrastructure, making cross-industry comparisons volatile.^[51] In rapidly evolving sectors, factors like technological obsolescence or regulatory shifts can render past data obsolete, complicating projections and risking misalignment with revenue growth assumptions in FCF models.^[52]^[53] Understating CapEx distorts FCF upward, potentially overvaluing firms and encouraging short-term decisions that harm long-term viability. In the energy sector, boom-bust cycles exemplify this: during oil price booms, aggressive CapEx drives negative FCF as companies expand production, but in busts, deferred maintenance CapEx temporarily boosts FCF—yet this often leads to future impairments and reduced output, as seen in cases where understated maintenance needs accounted for much of apparent distributable cash.^[54]^[55]^[56] To address these issues, analysts often normalize CapEx as a percentage of sales, using historical averages or industry benchmarks to project sustainable levels, which stabilizes FCF estimates across cycles.^[52]^[51] Additionally, conducting sensitivity analysis on CapEx assumptions in FCF projections helps quantify impacts of varying growth scenarios or industry changes, providing a range of outcomes rather than a single point estimate.^[57]^[46]

Agency Costs and Managerial Incentives

In agency theory, free cash flow (FCF) represents a potential source of conflict between managers and shareholders, particularly in firms with limited investment opportunities. Michael C. Jensen's seminal 1986 hypothesis posits that managers in low-growth companies with substantial FCF may prioritize personal or organizational expansion over value-maximizing payouts to shareholders, leading to inefficient resource allocation.^[58] This divergence arises because managers, whose utility often derives from controlling larger firms, are incentivized to retain and deploy excess cash in ways that do not enhance shareholder value, such as pursuing negative net present value (NPV) projects.^[59] Such agency problems manifest in overinvestment behaviors, including excessive spending on perks, pet projects, or unnecessary acquisitions that serve managerial interests rather than firm efficiency. Historical evidence from the 1980s conglomerate era illustrates this dynamic, where diversified firms accumulated FCF from mature divisions and funneled it into value-destroying mergers and expansions, contributing to widespread conglomerate discounts and eventual busts through leveraged buyouts and restructurings.^[58] These cases underscore how unchecked FCF enabled empire-building, eroding shareholder wealth as managers avoided distributing cash via dividends or buybacks.^[60] To mitigate these agency costs, mechanisms such as debt financing compel managers to commit future cash flows to fixed obligations, reducing discretionary FCF and disciplining investment decisions. Jensen emphasized that higher leverage substitutes for direct monitoring by forcing payouts and curbing overinvestment.^[58] Additionally, performance-based incentives linked to FCF metrics in executive compensation align managerial rewards with shareholder priorities, encouraging efficient cash management and innovation while curbing wasteful spending. From a broader perspective, observed FCF levels serve as an indicator of corporate governance quality; firms with high FCF that consistently prioritize payouts over retention signal stronger alignment with shareholder interests, whereas persistent retention without justification may reflect governance weaknesses and heightened agency risks.^[61]

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Growth Capex is the purchase of fixed assets to increase its operating cash flows, whereas Maintenance Capex is required to sustain itself.What is the Difference... · What is an Example of Growth...
[48]
Free Cash Flow Maintenance Capex Calculation - Old School Value
We are calculating FCF by subtracting both the capital expenditure that is used to maintain operations and to fuel future growth.Free Cash Flow Quick Recap · Free Cash Flow and...
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Understanding Free Cash Flow Series: Growth vs. Maintenance Cape
Jun 30, 2011 · The answer is simple; in most cases growth capex is an investment, while maintenance capex is a cost.<|separator|>
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None
Summary of each segment:
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[PDF] cashflow.pdf - NYU Stern
It is better to either estimate the change based on working capital as a percent of sales, while keeping an eye on industry averages. ▫ Negative Working ...
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Capital Expenditure (CapEx) - Financial Edge
Nov 26, 2024 · Challenges with Capital Expenditure · 1. High Initial Costs. Financial Strain: Significant upfront investment can strain cash flow and liquidity.What is Capital expenditure... · CapEx Formula · CapEx in Free Cash Flow...
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Can Standard Setters Improve Cash Flow Reporting of Capital ...
Mar 1, 2025 · We evaluate whether current capital expenditures (capex) reporting in the cash flows statement can be improved via disaggregation and/or reclassification of ...
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The Pitfalls of Free Cash Flow - FEI - Financial Executives International
Mar 3, 2020 · But the truth is, FCF yield sends short-term signals that too often run counter to maximizing the long-run value of a company.Missing: ROI | Show results with:ROI
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Let's Wait Awhile - E&Ps Worried About Oil Prices Keep Spending in ...
Sep 17, 2025 · Talos Energy is cutting capex by 30% in 2025. Most of the decrease was announced in its 2024 year-end earnings release, as it prioritizes FCF ...
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The Boom-Bust Cycle - Five Stages of the Oil Industry
Nov 5, 2015 · As the spending spree ensued, cash flow turned solidly negative by 2009, even though the price of oil was higher than it was in 2005. A recent ...
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Common Errors in DCF Models | Mistakes to Avoid - Wall Street Prep
The DCF model relies significantly on forward-looking projections and discretionary assumptions, making it prone to bias and mistakes.
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Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers
The free cash flow theory of capital struc- ture helps explain ... Jensen, Michael C., "The Takeover Con- troversy: Analysis and Evidence," Man ...
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[PDF] Agency Costs of Free Cash Flow, Corporate Finance, and ...
Jul 30, 2007 · Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers ... (May, 1986), pp. 323-329. Stable URL: http://links.jstor.org/sici ...
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[PDF] TAKEOVERS IN THE '60s AND THE '80s - Harvard University
This paper reviews the evidence on takeover waves of the 1960s and 1980s, and discusses the implications of this evidence for corporate strategy, agency theory, ...
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Agency cost of free cash flow, capital allocation, and payouts
Jensen's (1986) analysis of the agency costs of free cash flow radically transformed our understanding of corporate payout policy.