Agency Costs of Free Cash Flow
Free Cash Flow (FCF) agency conflicts exist when managers divert cash flow for private benefits. We identify the impact of unobservable FCF conflicts on firm policy using a structural approach. Measurement equations are constructed based on observable managerial choices: payout policy changes and personal portfolio decisions around exogenous tax rate changes. We find that FCF agency conflicts cause (i) under leverage, leading to higher corporate taxes and (ii) under investment in PP&E, leading to slower firm growth. Capital markets recognize FCF conflicts and discount such firms. Finally, firms with (i) large institutional holdings or (ii) better aligned executive compensation, suffer less from FCF agency conflicts.