FREE CASH FLOW Cash flows without any adjustment may be misleading because they do

FREE CASH FLOW Cash flows without any adjustment may be misleading because they do

not reflect the cash outflows that are necessary for the future existence of a firm. An alternative measure, free cash flow, was developed by Michael Jensen in his theoretical analysis of agency costs and corporate

takeovers. 10 In theory, free cash flow is the cash flow left over after the company funds all positive net present value projects. Positive net present value projects are those projects (i.e., capital investments) for which the present value of expected future cash flows exceeds the present value of project outlays, all discounted at the cost of capital. 11 In other words, free cash flow is the cash flow of the firm, less capital expenditures necessary to stay in business (i.e., replacing facilities as necessary) and grow at the expected rate (which requires increases in working capital).

The theory of free cash flow was developed by Jensen to explain behaviors of companies that could not be explained by existing eco- nomic theories. Jensen observed that companies that generate free cash flow should disgorge that cash rather than invest the funds in less profit- able investments. There are many ways in which companies can dis- gorge this excess cash flow, including the payment of cash dividends, the repurchase stock, and debt issuance in exchange for stock. The debt-for- stock exchange, for example, increases the company’s leverage and future debt obligations, obligating the future use of excess cash flow. If a company does not disgorge of this free cash flow, there is the possibility that another company—a company whose cash flows are less than its profitable investment opportunities or a company that is willing to pur- chase and lever-up the company—will attempt to acquire the free-cash- flow-laden company.

As a case in point, Jensen observed that the oil industry illustrates the case of wasting resources: The free cash flows generated in the 1980s were spent on low-return exploration and development and on poor diversification attempts through acquisitions. He argues that these companies would have been better off paying these excess cash flows to shareholders through share repurchases or exchanges with debt.

By itself, the fact that a company generates free cash flow is neither good nor bad. What the company does with this free cash flow is what

10 Michael Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Take- overs,” American Economic Review (May 1986), pp. 323–329.

11 The cost of capital is the cost to the company of funds from creditors and share- holders. The cost of capital is basically a hurdle: If a project returns more than its

cost of capital, it is a profitable project.

FINANCIAL STATEMENT ANALYSIS

is important. And this is where it is important to measure the free cash flow as that cash flow in excess of profitable investment opportunities. Consider the simple numerical exercise with the Winner Company and the Loser Company:

Winner Loser Company Company

Cash flow before capital expenditures $1,000 $1,000 Capital expenditures, positive net present value projects

(750) (250) Capital expenditures, negative net present value projects

0 (500) Cash flow

$250 $250 Free cash flow

$250 $750 These two companies have identical cash flows and the same total

capital expenditures. However, the Winner Company spends only on profitable projects (in terms of positive net present value projects), whereas the Loser Company spends on both profitable projects and wasteful projects. The Winner Company has a lower free cash flow than the Loser Company, indicating that they are using the generated cash flows in a more profitable manner. The lesson is that the existence of a high level of free cash flow is not necessarily good—it may simply sug- gest that the company is either a very good takeover target or the com- pany has the potential for investing in unprofitable investments.

Positive free cash flow may be good or bad news; likewise, negative free cash flow may be good or bad news:

Good News Bad News

Positive free The company is generating sub- The company is generating more cash flow

stantial operating cash flows, cash flows than it needs for beyond those necessary for

profitable projects and may profitable projects.

waste these cash flows on unprofitable projects.

Negative free The company has more profit- The company is unable to gener- cash flow

able projects than it has oper- ate sufficient operating cash ating cash flows and must rely

flows to satisfy its investment on external financing to fund

needs for future growth. these projects.

Therefore, once the analyst calculates free cash flow, other informa- tion (e.g., trends in profitability) must be considered to evaluate the operating performance and financial condition of the firm.

Cash Flow Analysis