The Perils of Free Cash Flow, Avoidance of Outside Monitoring, and the Exploitation of the Internal Capital Market

Download or read book The Perils of Free Cash Flow, Avoidance of Outside Monitoring, and the Exploitation of the Internal Capital Market written by Brandon N. Cline and published by . This book was released on 2012 with total page 47 pages. Available in PDF, EPUB and Kindle. Book excerpt: While internal capital markets may afford firms a real option to avoid costly outside financing [Matsusaka and Nanda (2002)], we show that they also provide an option to avoid the monitoring that accompanies the raising of capital. Consistent with this view, we find conglomerates which cross-subsidize divisions or engage in value-destroying investment avoid oversight from the external capital markets by refraining from issuing capital or paying dividends. We further show that firms that issue capital while operating inefficient internal capital markets suffer significant negative abnormal SEO announcement returns in excess of other diversified firms conducting SEOs. Evidence likewise indicates that these firms suffer from a free cash flow problem. High coincident levels of free cash flow and investment are responsible for these inefficient capital allocations, the acceptance of value-destroying investments, and overall lower long-run firm value. However, we show that the issuance of capital is associated with additional oversight and those firms issuing capital garner significantly more attention from the analyst community. The additional analyst oversight significantly mitigates the free cash flow problem and is ultimately linked to higher firm value.