Free Cash Flow Problem and Japanese Companies

ARIKAWA Yasuhiro
Faculty Fellow, RIETI

In recent years, the free cash flow of Japanese companies has been increasing. Based on figures provided by the Ministry of Finance's Financial Statements Statistics of Corporations by Industry, free cash flow of Japanese companies stood at about negative ¥6 trillion in 1990 but rose to some positive ¥10 trillion in 2000, and ¥23 trillion in 2003, thus increasing 2.3 fold in three years (see note 1). Along with free cash flow, the ratio of cash and deposits to total assets has basically been trending upward since 2000 for companies (except for those on Mothers) listed on the Tokyo Stock Exchange (TSE).

Free cash flow problem arising from over-investment

The retained surplus of companies is often taken as an indicator of management inefficiency. Indeed, it has been pointed out that companies prone to become a target of a hostile takeover characteristically have a large amount of retained surplus (see Xu, 2006). Behind such a negative view on companies maintaining large holdings of internal funds is the so-called free cash flow hypothesis. Corporate managers would have substantial discretion over the use of internally retained funds and it would be difficult to mandate managers beforehand, for instance by contract, to put such funds to optimal use. The consequence of this would be a high possibility that corporate managers make inefficient decisions on the use of internal funds. Some empirical findings also point to this trend. Lang, Stulz and Walking (1991), for instance, show there is a high probability that mergers and acquisitions (M&As) fail to increase shareholder value when the acquiring company has relatively high cashflows but without investment opportunities with Tobin's q (see note 2) below 1.

Meanwhile, Malmendier and Tate (2005) point out that the free cash flow problem may occur when corporate managers are too optimistic about their companies' futures. Why does managerial overconfidence result in this problem? To answer this, let's say there is a certain company considering a new investment opportunity. Here, it is also assumed that the market is quite rational in assessing the future profitability of the investment project whereas the manager of the company is more optimistic. In this case, the cost of external funds imposed by the market would be too high for the manager, hence, lower incentive for the manager to undertake the capital investment by raising funds from external sources. Under such a situation, the greater the scale of the funds held internally, the more aggressively the company would be able to invest. What is important here is that it is highly possible that an internally financed investment project was carried out because the manager was overconfident about its future profitability. From the viewpoint of shareholders, such a project would represent a case of overinvestment in which the free cash flow problem has manifested.

Holdings of cash and deposits can be justified by two factors

Holdings of cash and deposits by companies, however, should not always be cast in a negative light as such corporate behavior can be justified by two factors. The first factor is the presence of transaction costs. For instance, in cases where a company has an urgent need for funds, and if the cost of external funds is very high, the presence of large holdings of internal funds is desirable in terms of maximizing the company's shareholder value. The second factor is the asymmetric information problem. Where information asymmetry exists between a company and the external market, cash and deposits held by the company are the least expensive source of funds, which provides an incentive for corporate managers to accumulate retained earnings. The positive relation between future investment opportunities and the ratio of cash and deposits is common to both these factors, i.e. the greater the expected investment opportunities in the future, the higher the ratio of cash and deposits. That is, given that the two factors - transaction costs and information asymmetry - are at work, the cost of failing to raise funds would be greater for companies with more investment opportunities, and therefore such companies would be more inclined to hedge against the risk of losing investment opportunities by maintaining large holdings of cash and deposits even if they can expect comparatively lower returns on this form of asset.

Indeed, when I estimated the determinants of holdings of cash and deposits with respect to companies listed on the TSE (except for those on Mothers), I found those with greater future investment opportunities, as measured by Tobin's q, were holding greater amounts of cash and deposits. Also, it was confirmed that the smaller the size of the company (as measured by the logarithm of the amount of total assets), the higher the ratio of cash and deposits. Because it is presumed that smaller companies are more likely to face the asymmetric information problem, the above findings can be seen to imply that a company is more inclined to maintain large holdings of cash and deposits when the asymmetric information problem between it and the external market is more serious (see note 3). As mentioned earlier, the portions of cash and deposits attributable to the two factors would not contradict the goal of maximizing shareholder value.

With respect to Japanese companies' moves to enhance shareholder returns, it has been pointed out that there is a problematic tendency among some companies to pay dividends to cater to market expectations even when their fundamental values do not support such payouts (see Tanigawa, 2006). In terms of maximizing shareholder value, delivering shareholder returns from excess funds is fully justifiable within the scope of preventing the free cash flow problem, and companies are rightly required to strengthen their governance structure based on that viewpoint. Should they go beyond that scope to deliver shareholder returns -- whether in the form of dividend payouts or through retirement of own shares -- to the extent of cutting into the portions of cash and deposits that should and need to be reserved for future investment opportunities or because of the asymmetric information problem, there is a high possibility that such delivery of shareholder returns would not ultimately lead to the maximization of shareholder value.

March 7, 2006
  1. Free cash flow is defined as net income plus depreciation and amortization expenses and capital expenditures.
  2. See Tobin's q theory, an investment theory developed by James Tobin, an American economist. Tobin's q is defined as a value derived by dividing the market value of a company by the replacement cost of its assets.
  3. Similar results have been obtained in Opler et al (1999) based on data of U.S. companies.

Xu Peng (2006), "What are the Characteristics of Companies Prone to Become a Hostile Takeover Target?" RIETI Discussion Paper 06-J-008

Tanigawa, Yasuhiko (2006), "Kabunushi kangen no arikata" (Shareholder Returns: The Way they are Supposed to be), mimeo

Lang, L. H. P., R. M. Stulz and R. A. Walking (1991), "A test of the free cash flow hypothesis: the case of bidder returns," Journal of Financial Economics 29: 315-335

Malmendier U. and G. Tate (2005), "CEO overconfidence and corporate investment," Journal of Finance 60: 2661-2700

Opler, T., L Pinkowitz, L. R. Stulz and R. Williamson (1999), "The Determinants and Implication of Corporate Cash Holdings," Journal of Financial Economics 52: 3-46

March 7, 2006

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