Financial

Financial Ratio Analasis

Corporate managers are the agents of shareholders, a relationship fraught with

conflicting interests. Agency theory, the analysis of such conflicts, is now a major part of

the economics literature. The payout of cash to shareholders creates major conflicts that

have received little attention.1 Payouts to shareholders reduce the resources under

managers' control, thereby reducing managers' power, and making it more likely they

will incur the monitoring of the capital markets which occurs when the firm must obtain

new capital (see Easterbrook, 1984, and Rozeff, 1982). Financing projects internally

avoids this monitoring and the possibility the funds will be unavailable or available only

athigh explicitprices.Competition in the product and factor markets tends to drive prices towards

minimum average cost in an activity. Managers must therefore motivate their

organizations to increase efficiency to enhance the problem of survival. However,

product and factor market disciplinary forces are often weaker in new activities and

activities that involve substantial economic rents or quasi rents.

2

In these cases,

monitoring by the firm's internal control system and the market for corporate control are

more important. Activities generating substantial economic rents or quasi rents are the

typesof activitiesthatgeneratesubstantialamountsof free cash flow.The agency costs of debt have been widely discussed, but the benefits of debt in

motivating managers and their organizations to be efficient have been ignored. I call

theseeffectsthe "controlhypothesis"for debtcreation.

Managers with substantial free cash flow can increase dividends or repurchase

stock and thereby pay out current cash that would otherwise be invested in low-return

projects