This paper focuses on using accounting information to better explain the relationship between free cash flow and overinvestment. In doing so, it is the first paper to offer large-sample evidence of overinvestment of free cash flow.
The paper uses an accounting-based framework to measure both free cash flow and overinvestment. Free cash flow is defined as cash flow beyond what is necessary to maintain assets in place and to finance expected new investments. Overinvestment is defined as investment expenditure beyond that required to maintain assets in place and to finance expected new investments in positive net-present-value (NPV) projects.
To measure overinvestment, the author decomposes total investment spending into two parts: (i) required investment expenditure to maintain assets in place, and (ii) new investment spending. The author then decomposes new investment spending into overinvestment in negative NPV projects and expected investment expenditure; the latter varies with the firm’s growth opportunities, financing constraints, industry affiliation and other factors.
The author also examines whether governance structures are effective in mitigating overinvestment. Consistent with prior research, the author finds that out of a large set of governance measures only a few relate to overinvestment. The author also finds that firms with activist shareholders and certain anti-takeover provisions are less likely to overinvest free cash flow.