How do contracts adapt to an increase in free cash flow?

Theodore Hershel Goodman, University of Pennsylvania

Abstract

In this paper, I examine the relation between cash flow from operations in excess of growth opportunities (free cash flow) and firm contracts. This paper is divided into two chapters. In the first chapter, I investigate the changes in governance mechanisms designed to control the agency costs associated with free cash flow. While I find little evidence of sweeping changes in governance mechanisms by firms that experience a large persistent increase in free cash flow, there is evidence that firms that already have mechanisms in place to align managers with shareholders (high equity ownership) retain these mechanisms and firms with low alignment between managers and shareholders initiate changes (CEO turnover). In the second chapter, I analyze the extent to which firms smooth investment around changes in cash flow through debt financing or changes in cash reserves. I find evidence consistent with the presence of information predicting future cash flow reducing the costs of external financing and limiting under-investment. I also find evidence that managers anticipate cash flow shortfalls when making deposits into cash balances. This evidence suggests that information about the pattern in firm cash flow can affect investing and financing decisions.

Subject Area

Accounting

Recommended Citation

Goodman, Theodore Hershel, "How do contracts adapt to an increase in free cash flow?" (2005). Dissertations available from ProQuest. AAI3197674.
https://repository.upenn.edu/dissertations/AAI3197674

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