A Research On Free Cash Flow, Discretionary Expenditure And Corporate Performance Decline

With the rapid development of China economy and the establishment of modern corporate system in China, how to find a way to reduce the agency costs and discretionary expenditure to keep the sustainable growth in those companies, which have substantial cash flow during the mature period, is a current problem in modern financial theory and application. The paper is on shareholder's behalf to probe into the corporate performance decline from a more observable angle. We explores the superfluous cash flow of company how to influence corporate financial policy, such as expenditure behavior and how to encumber the growth of corporate performance. The paper wants to exposure the hidden intention behind the financial policy and help corporate shareholders protect their own rights and enhance corporate administration and supervision. Also it provides guidance to corporate managers and correlative government institution to support their decision-making through theory analysis and empirical study.Based on the theory of agency, the theory of property rights and the theory of the ownership structure of the firm, Michael C. Jensen developed a hypothesis of free cash flow. He points out "Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies. " Then Jensen had given two ways to solve the problem: debt and takeover. In the paper, firstly the free cash flow theory and relative researches are summarized and analyzed from every process of corporate financial management, such as corporate financing, investment and stock dividend etc., and I provide my own ideas to apply and develop free cash flow theory in China, that is, we should pay attention to the fact of the incompleteness of markets, the gamble on the markets, the flaw of internal control systems and the means to reduce agency costs of free cash flows etc. Secondly, discretionary expenditure is an important evidence of agency costs in my eyes. When the company generates large free cash flow, managers have incentives to act in their own best interests, such as making their firms grow beyond the optimal size, enjoying luxury office facilities and so on, that means the increase of discretionary expenditure. Discretionary expenditure is irrelative to the future growth of company. It neither gains short-term profit nor achieves long-term development. Discretionary expenditure shows in the forms of investment failure, tunneling, over investment and "corporate fat" etc. The paper also analyzes some distinct phenomenon in Chinese public listed companies, such as changing the direction of raised money, unrelated diversified investment and abnormal huge expenditure etc. Thirdly, discretionary expenditure will result in the growth of corporate performance decline, in another word, large free cash flow leads high discretionary expenditure, and high discretionary expenditure baffles the sustainable growth of corporate performance. Eventually this will make the mature companies lack attractive and energetic, which is harmful to shareholders.The paper also provides support for my viewpoints with empirical study. I have used over 5000 financial data of China public listed companies from 2000 to 2005 as the sample to examine and find evidence of a free cash flow problem. My conclusions are as follows:(1)The firms with less profitable investment opportunities and large free cash flows, compared with those firms with large and highly profitable investment projects but without free cash flow, previous ones have higher level of discretionary expenditure. And the high discretionary expenditure is not only as a result of high free cash flows, but also is an important evidence of agency costs. (2)The relation between discretionary expenditure and free cash flow of current period or previous period is a remarkably positive correlation in the firms with huge free cash and less profitable investment opportunities. This illuminates that the level of discretionary expenditure is influenced by free cash flow, especially in those firms with agency costs of free cash flow. (3) Debt reduces the positive correlation between discretionary expenditure and free cash flow, but compared with other countries' findings, the benefits of debt are weaker. So the financial system in China should be intensified. (4) The relation between free cash flow and corporate performance denoted by EVD and ROA is positive correlation, which shows free cash flow itself is not harmful to the corporate, but it could cause agency costs so that the relation between discretionary expenditure and corporate performance denoted by EVD and ROA is negative correlation. (5) I find out the relation between free cash flow and corporate performance increase denoted by EVD and ROA in the three consecutive years is negative correlation as well as the relation between discretionary expenditure and corporate performance denoted by EVD and ROA is negative correction. More free cash flow did not bring corporate higher performance. Indeed there are more free cash flows; there are higher discretionary expenditure and slower corporate performance improving. This is the agency cost of free cash flow.Facing the current situation of China, this paper provides the related strategies from internal level to external level to help corporate reduce the agency costs of free cash flow and discretionary expenditure.In this research, this paper has the following innovations: 1) Created "Management Cash Flow" Concept. In terms of financial objective, this concept explains that management is trying to maximize own interests. Researching free cash flow agency should focus on Management Cash Flow. 2) Discussed Discretionary Expenditure and the related terms. Based on Hackle' s theory of discretionary expenditure dichotomy, according to China' s reality, firstly brought forward the concept of "New Dichotomy", which means discretionary expenditure includes discretionary operation expenditure (divided to discretionary income expenditure and discretionary capital expenditure) and discretionary non-operation expenditure. Furthermore, This paper has researched discretionary expenditure' s outlook and common scalability. This paper illustrates that "tunneling" , which is one of the forms of discretionary non-operation expenditure, is very common in China. Viewed from subjective and external angels, Discretionary capital expenditure can be divided to investment mistake and over investment. 3) This paper also completes the logic illation of relationship of free cash flow, discretionary expenditure and corporate performance. The conclusion is that a mature enterprise, which has vast cash flow, is ease to have free cash flow agency issue. Discretionary expenditure increasing leads to the slower growth and lower efficiency. 4) This research empowers the related economy theories explain discretionary and free cash agency cost. As for the information asymmetry theory, this paper concludes management has discretionary expenditure problem because of information asymmetry, it will be worse if cash flow is positive. As for conduct financial theory, this paper illustrates management' s over optimism and over confidence causes the decision is not totally rational. It is basis of psychology to explain discretionary expenditure. This is main reason caused over investment and investment mistake. As for the financial layered management, management is easy to conduct discretionary expenditure with abundant free cash flow. Therefore, it' s necessary for the shareholders construct a set of effective financial system to supervise management fulfill the financial objective so that the management free cash flow agency cost can be reduced.Also this paper makes logical illation basing on mainstream of the financial management theories while the conclusions are supported by China public listed companies as the sample to have been processed empirical validation. Although as a creative research, it needs the deeper researches to be verified and improved in the future.