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Agency Cost - the Debt Policy of the Firm

Essay by   •  April 10, 2017  •  Essay  •  896 Words (4 Pages)  •  1,132 Views

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Results for the debt policy of the firm is also accordance to free cash flow theory that the optimal level of leverage in firm capital structure can reduce the free cash flow that is under the control of the manager. By using more debt in the capital structure manager give right to the debt holder that they can bring the firm in to the court if they do not make the interest and principal payments to them. More usage of debt increase the bankruptcy risk of the firm and the risk of losing jobs for the manager so they avoid investing free cash flow in the negative NPV projects. Thus debt is also a controlling mechanism of agency cost of free cash flow like the dividend. Li et al. (2003) argued that high debt in the capital structure increase the creditors concern about the interest and principal payments and they have more incentives in monitoring the manager’s action. As a result of high debt in capital structure reduce the agency cost. Fleming (2005) concluded that a firm by using optimal level of debt in their capitals structure can control their agency cost of free cash flows. The investment and growth opportunities (Tobin Q) of the firm increase the agency cost associated with the free cash flow. As the firm with more growth and investment opportunities of the firm hold more free cash to avoid the forego of any profitable project because of lack of cash availability. Hence the managers of the firm with more investment and growth opportunities hold more free cash that is misused by the manager. This increase the monitoring need of their activities which in result in crease the agency cost associated with the free cash flow our result is also consistent with the so many previous studies. Ferreira et al (2004) pointed out that the firms with better investment opportunities have greater financial distress costs because the positive NPV of these investments disappears in case of bankruptcy. In this case, firms with better investment opportunities will keep higher levels of cash to avoid financial distress. Opler et al (1999) reported that the firm prefers to hold more cash if they have profitable investment opportunities which leads towards the increase in the agency cost of free cash flow. The results of the joint model of the study shows that the managerial ownership is negatively associated with the free cash flow that is with accordance with the free cash flow theory that managerial ownership can reduce the free cash flow problem but the insignificance result of the study is due to less number of outstanding shares that are owned by the manager. In Pakistani context the managerial ownership is not an effective way of controlling the agency cost of free cash flow. The results of the study also revealed that the profitable firm carry more free cash flow that is under the control of the manager can be used by them for their own discretionary purposes. Utami et al (2011) reported that firm profitability increase the firm cash under the control

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