Test For Hypothesis Of Free Cash Flow From The Perspective Of Discretionary Expenditure

The Hypothesis of Free Cash Flow(FCF) was proposed by Jensen in 1986, the main points including:①When a company holds large amounts of free cash flow but lacks positive NPV projects, there are conflicts of interest between shareholders and managers in the use to the free cash flow, managers tend to use cash into significant investments or private consumption, and they even invest in negative NPV projects rather than return the cash to shareholders. As a result, the conflicts cause the agency problem between them, and agency cost is inevitably occurred.②During the period of low growth, the more free cash flow a company holds, the more serious the agency problem is caused. Jensen also pointed that increasing liability is a important way to solve the agency problem caused by free cash flow, because increasing liability can strengthen the supervision and restriction on managers, this point is one of the inferences of the hypothesis, and is often called"Control Hypothesis".This paper tests hypothesis of free cash flow from the perspective of discretionary expenditure. As a new concept, discretionary expenditure (DE) was first proposed by Henkel, he defined discretionary expenditure as the expenditure that has nothing to do with the company's future growth, including discretionary income expenditure (DIE) and discretionary capital expenditure (DCE). This paper considers DE as the specific forms of the agency cost and can reflects the level of the agency costs to a certain extent. Therefore, based on hypothesis of free cash flow, I propose two new assumptions:①The more free cash flow a company holds ,the greater DE , DCE and DIE it probably spends.②For a company which has high FCF but grow slowly, the higher the liability ratio is, the smaller the positive correlation between DE and FCF is.This paper also provides support for my assumptions with empirical study. I have used 5250 financial data of China A-share listed companies from 2006 to 2010, as the sample to test the hypothesis of free cash flow. I did significance tests and multiple linear regression analysis by SPSS 12.0. The conclusions of significance tests are as follows:①Compared to low FCF group, the level of DE and DCE of High FCF group both are significantly different;②For those companies which have high FCF but grow slowly, the level of DE between high liability group and low liability group is significantly different. My conclusions of multiple linear regression analysis are as follows:①There is significant positive correlation between DE and FCF, and for High FCF & Low Growth group, this positive correlation is enhanced;②For High FCF & Low Growth group, liability will weaken the positive correlation between DE and FCF. Apparently, empirical test results are consistent with both hypotheses, indicating that the hypothesis of free cash flow is applicable in China.