Question

Suppose unexpected events in the market for your product leave you with significant free cash flow. What benchmark should you use in determining the best (and most ethical) use of those funds?

What would you do as the CEO?

Reading:

In Shakespeare’s As You Like It, Rosalind—the lovesick heroine—wonders, “Can one desire too much of a good thing?” By “thing,” she specifically meant love, but the implied answer has transformed the question into a common expression—you can’t get enough of a good thing. As the chapter notes, free cash flow is a good thing because a firm blessed with it has already met all operating needs and paid for all investments in net cur-rent and net fixed assets. But once a firm has covered these, is more cash always better? Paradoxically, Harvard finance professor Michael Jensen replied, “not always,” in a classic 1986 paper. To argue the point, Jensen returned to the potential conflict between share-holders (principals) and management (their agents). Shareholders want management to focus on share price. But sometimes the CEO has a different agenda—such as boosting company size, perhaps to raise his profile and trigger lucrative employment offers from other firms. The weaker the shareholders’ control, the more likely management will pursue its own interests. And free cash flow, according to Jensen, gives management resources to play with. Imagine a mature firm with healthy cash flows but an uncertain future. In the original article, Jensen pointed to the oil industry, which remains a good example. Between 1973 and 1980, sup-ply disruptions from Middle Eastern conflict and the Iranian Revolution produced an 11-fold increase in crude-oil prices. Because it is tough to reduce commutes or trade in gas-guzzlers over-night, oil companies reaped a short-term bonanza, pumping out billions in free cash flow. In the long run, however, consumers can move and buy new cars; firms can also build more energy efficient factories. They did and by 1986 oil prices were 71% below the 1980 peak. In the meantime, however, oil companies spent that mountain of cash on exploration and acquisitions of firms outside the oil business—neither of which did more for shareholders than they could have done for themselves had oil-company management simply paid out the surplus cash as dividends. This is not to imply more free cash flow is always bad. Often, small, younger firms find themselves in the exact opposite position of early 1980s oil companies—they are flush with great projects but cash poor. Because of their short track record and thin col-lateral, such firms often must fund investment projects with internal funds because borrowing is too expensive or impossible. In this case, excess cash is great because it allows management to exploit opportunities that might oth-erwise go by the wayside. The bottom line for management is—the best way to keep shareholders happy is to focus on what is best for them. Or, as the Bard more poetically put it in King Lear, “How, in one house, should many people under two commands hold amity? ’Tis hard; almost impossible.”

Answer 1