The impact of free cash flow in technology firms with R&D expenditures

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The Impact of Free Cash Flow in Technology Firms with R&D

expenditures

Name: Yu Zhang

Student number: 11845929

Thesis supervisor: Alexandros Sikalidis Date: June 25, 2018

Word count: 12760

MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam

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Statement of Originality

This document is written by student Yu Zhang who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

The research purpose is to explore the relationship of free cash flow with the performance of technology firm with R&D expenditures, and the role of corporate governance in the relationship. Data of 1348 US listed companies with R&D expenditures from 2009-2017 are used to empirically examine the hypothesizes. It is found that free cash flow has a negative impact on firm performance and this negative relationship can be mitigated by the board size in the specific setting. The study provides a better understanding of the association among free cash flow, firm performance and corporate governance in technology firms with R&D expenditures.

Key words: free cash flow, firm performance, corporate governance, agency problems, agency theory

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Contents

1. Introduction ... 5

2. Literature review and contributions ... 7

2.1. An overview of former literature ... 7

2.2. Discussion and contribution ... 11

3. Hypothesis development ... 14 3.1. Hypothesis 1 ... 14 3.2. Hypothesis 2&3 ... 15 4. Research Design ... 17 4.1. Sample ... 17 4.2. Independent Variables ... 17 4.3. Dependent Variable ... 18 4.4. Control Variables ... 19 4.5. Hypothesis Models ... 20

5. Results and Analysis ... 23

5.1. Results ... 23

5.2. Analysis ... 26

6. Conclusion ... 29

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1. Introduction

This paper use a sample of US listed firms with R&D (research and development) expenditures to test whether and how free cash flows and corporate governance impact firms performance. In perfect capital markets, there would be no link between free cash flows and firm level investments (Modigliani and Miller, 1958). However, prior research has documented a positive relation between them (Hubbard, 1998). Myers and Majluf (1984) show that, in imperfect capital markets, information asymmetries increase the cost of capital and it is costly for firms to raise external finance. Hence, external financing constraints force firms to reduce feasible investments and to invest more in the presence of internally generated free cash flows due to its lower cost of capital (Fazzari et al., 1988; Hoshi et al., 1991; Whited, 1992; Hubbard, 1998). Agency problem stem from the separation of corporate ownership and control, exhibiting over-investment where managers in firms with free cash flows have strong incentive to invest in negative NPV projects (Jensen, 1986; Stulz, 1990).

On the other hand, technology development is more and more important in nowadays. Technology can be most broadly defined as the entities, both material and immaterial, created by the application of mental and physical effort in order to achieve some value. In this usage, technology refers to tools and machines that may be used to solve real world problems. Neoclassical growth theory outlines the three factors necessary for a growing economy, and one of the most important factor is technology. Technology is thought to augment labor productivity and increase the output capabilities of labor. In the accounting field, the technology development can be represented in the research and development expenditures on the financial reports. R&D is a type of systematic activity conducted by a company, which combines basic and applied research in an attempt to discover solutions to problems, or to create or update goods and services. The act of a company conducting its own R&D often results in the ownership of intellectual property in the form of patents or copyrights. An important component of a company's R&D is its R&D expenditures. These expenses can be relatively minor, or they can easily run into billions of dollars for large corporations. R&D expenses are usually the highest for industrial, technological, health care and pharmaceutical firms. Some companies reinvest a significant portion of their profits back into R&D, as is the case with technology companies, since they see it as an investment in their continued growth.

This paper will focus on research technology firms with R&D expenditures in order to provide an insight on how to evaluate the performance of these kind of firms. First, in some extent, firms with R&D expenditures are more focus on innovation and technology development, so it is very

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important to know about the performance of these kind of firms since they are the major support of our social development. On the other hand, firms with R&D expenditures usually have high requirement of cash and it is more meaningful to evaluate if they utilize the cash in a way that can create value.

Another dimension need to mention is that high tech sector in the stock market has become very hot due to its unexpected future development and potential of surprise earnings. However, how to predict the future performance of firms with research and development expenditures is not easy. Financial report is normally regard as back forward looking, however, is it possible that we can use the fundamentals of financial report to forecast the future development of a firm? For example, free cash flow is very important in of firms with research and development expenditures since these firms usually need a lot of cash to support their research and development. Moreover, free cash flow is usually treated as an indicator of agency problems, which also can influence the performance of a firm. If we can find a relationship between free cash flow, agency problems and the performance of of firms with research and development expenditures, that will be very meaningful to investors.

According to the results of the regression, there is a statistically significant, negative relation exists among free cash flow, firm performance. High free cash flow do have a negative impact on the future performance due to the agency problems, and this effect can be reduced by enlarging the size of board in the technology firms.

Section 2 of the study provides an overview of the relevant literature. Section 3 describes hypothesis development. Section 4 outlines the data and research design, methodology applied. Section 5 summarizes the results and relevant analysis. Last, Section 6 presents the conclusion.

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2. Literature review and contributions

2.1. An overview of former literature

The thesis is related to four streams of literature.

First, it relates to the literature on the agency theory. The Agency theory or principal–agency theory in political science and economics is theory around agents: a person or entity (the "agent"), who is able to make decisions on behalf of, or that impact, another person or entity: the "principal". The dilemma exists in circumstances where the agent is motivated to act in his own best interests, which are contrary to those of the principal, and is an example of moral hazard. The agency problem in management derives from the separation of ownership and control. The first complete study regarding the agency theory and free cash flow theory was conducted by Jensen and Meckling (1976), in which free cash flow is defined as net cash flows after deducting the needs of positive NPV projects.

Second, the thesis relates to the free cash flow theory. The free cash flow theory states that when a company has generated an excessive surplus of free cash flow and there are not profitable investment opportunities available, management tends to abuse the FCF in hands so as to resulting in an increase in agency problems, inefficient allocation of resources, and unreasonable investment. In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) is a way of looking at a business's cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, and convertible security holders when they want to see how much cash can be extracted from a company without causing issues to its operations. Free cash flow can be calculated in various ways, depending on audience and available data. A common measure is to take the earnings before interest and taxes multiplied by (1 − tax rate), add depreciation and amortization, and then subtract changes in working capital and capital expenditure. Depending on the audience, a number of refinements and adjustments may also be made to try to eliminate distortions.

Third, this thesis relates to the firm performance. A measure of performance of a company that may not only depends on the efficiency of the company itself but also on the market where it operates. In the financial sector, it also known as financial stability or financial health. There are different financial measures that can be used in order to evaluate the performance of a company. Some of the common financial measures are: revenue, return on equity, return on assets, profit

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margin, sales growth, capital adequacy, liquidity ratio, and stock prices, among others. Depending on the industry on which the company operates, some financial ratios will be more meaningful than others. For instance, in a manufacturing company, total unit sales, return on assets and inventory turnover may be key ratios to monitor, while for financial institutions, stock prices, cash flow, revenue and operating income may the key ratios to monitor.

Forth, this thesis relates to corporate governance. Corporate governance is the system of rules, practices and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community. Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.

2.2. The Free Cash Flows Hypothesis

The free cash flow hypothesis proposed by Michael C. Jensen (1986) has another name: the agency cost theory of free cash flow. The free cash flow hypothesis stems from the agency problem. In corporate activities, the discretionary reduction of free cash flow can ease the conflict between the shareholders and the management. The amount of cash. Jensen (1986) believes that the free cash flow should be fully delivered to shareholders, which will reduce the power of the agent, and that the funds required for the reinvestment of the investment plan will be controlled in the capital market, and thus the agent problems can be reduced. Apart from using free cash flow to invest in projects with negative NPV, managers tend to make unnecessary expenditures aligned with their personal interests. Tangible or intangible assets unrelated to company operations may be purchased in the firm's name, but function purely for a manager's personal use. According to La Porta et al. (2000), overinvestment and personal expenditures are seen even in environments with stricter investor protections. Acquiring firms that are not feasible investments is also seen more frequently at firms with greater free cash flow (Opler, Pinkowitz, Stulz, & Williamson, 1999). Lang, Stulz, and walking (1991) show that companies with a high level of FCF and low growth opportunities have negative returns during the period of the announcement of the purchases. Steven and al. (2003) have found on a sample of 552 companies that the yields, during the period of the announcement of the purchases of assets, are related negatively to the amount of FCF particularly for companies with low growth opportunities. Zhou blow and Al (2012) conducted a study on a sample of Chinese companies for the period 2006-2010. They examined the relationship

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for managers and investors. The results showed the negative relationship between the free cash flow of the company and the financial performance.

According to the free cash flow hypothesis, excessive free cash flow in the hands of managers leads to overinvestment due to investment in projects with negative net present value (Jensen, 1986; Jensen & Meckling, 1976). While this reduces profitability and company worth, it helps managers to control a greater amount of wealth or assets. Ac- cording to this hypothesis, managers of firms with a high amount of free cash flow avoid market checks. These managers do not feel the need for external funds for investments or expenditures; therefore, they are not subjected to the investigation or regulation of lenders or shareholders. In the event that funds are provided by capital markets; ample, detailed information needs to be shared with market participants and more these bring more questions that have to be answered by the managers. Rubin (1990) and Lang, Stulz, and Walkling (1991) argued that managers prefer to use any free cash flow remaining after investment negative-NPV projects to continue to invest in such projects rather than pay out dividends.

2.3. The Agency Theory

Jensen (1986, 1) states that: “payouts to shareholders reduce the resources under managers’ control, thereby reducing managers’ power”. According to Sloan (2001, 340) “The basic agency problem resulting from the separation of management and financing is that the managers will have incentives to take actions to increase their own utility, but not to maximize the returns on capital invested by the investors”. Moreover, In order to optimize personal bonuses and compensation, managers are likely to retain and over-invest FCF in order to generate sales growth—a variable likely to be highly associated with management compensation. Since high levels of FCF significantly increase managers’ powers, accelerate risky capital expenditure activities and prompt managers to override firms’ internal control. When internal controls are weak, managers would be more likely to manipulate cash flows by choosing investment projects that are beneficial to them rather than to shareholders. Under such circumstances, managers incline towards weak controls and use cost benefit principle as the rationale for those poor controls (Caplan1999).

additional income in addition to wages through on-the-job consumption results in damage to the interests of the owner.

Literature suggests that the corporate governance may play a role in reducing agency problems. A great amount literature on such agency-theoretic explanations of corporate governance and capital structure can be found(Harris and Raviv 1991 and Myers 2001). Under virtually any theory of

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agency costs, ownership structure is important, since it is the separation of ownership and control that creates agency costs (e.g., Barnea, Haugen, and Senbet 1985). Greater financial leverage may affect managers and reduce agency costs through the threat of liquidation, which causes personal losses to managers of salaries, reputation, perquisites, etc. (e.g., Grossman and Hart 1982, Williams 1987), and through pressure to generate cash flow to pay interest expenses (e.g., Jensen 1986), the conditions under which the firm is liquidated (e.g., Harris and Raviv 1990), and dividend policy (e.g., Stulz 1990). Greater insider shares may reduce agency costs, although the effect may be reversed at very high levels of insider holdings (e.g., Morck, Shleifer, and Vishny 1988). As well, outside block ownership or institutional holdings tend to mitigate agency costs by creating a relatively efficient monitor of the managers (e.g., Shleifer and Vishny 1986). Higher leverage can mitigate conflicts between shareholders and managers concerning the choice of investment (e.g., Myers 1977), the amount of risk to undertake (e.g., Jensen and Meckling 1976, Williams 1987).

2.4. Firm Performance Measurement

Measurement of performance can offer significant invaluable information to allow management’s monitoring of performance, report progress, improve motivation and communication and pinpoint problems (Waggoner, Neely & Kennerley, 1999). Performance measurement is critical for effective management of any firm (Demirbag, Tekinus and Zaim, 2006). The process improvement is not possible without measuring the outcomes. Hence, organizational performance improvement requires measurements to identify the level to which the use of organizational resources impact business performance (Gadenne and Sharma, 2002; Madu, Aheto, Kuei and Winokur, 1996). Accordingly, it is to the firm’s best interest to evaluate its performance. Nevertheless, this is a management area characterized by lack of consistency as to what constitutes organizational performance. According to Cameron and Whetten (1983). Performance of a firm is significantly impacted by corporate governance and if the functions are appropriately established for the corporate governance system, it attracts investment and helps in maximizing the company’s funds, reinforcing the company’s ability to tackle with unexpected issues and also provide a good basement to create improvement in firm performance. That is to say, an effective corporate governance facilitates remarkable growth, protects against probable financial challenges and hence, corporate governance plays an definitely important role in the increase of the firm performance. Currently the impact of corporate governance upon the general firm well-being has been examined (Ehikioya, 2009).

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2.5. Corporate Governance

Gompers, Ishii, and Metrick (GIM, 2003) find that stock returns of firms with strong shareholder rights outperform, on a risk-adjusted basis, returns of firms with weak shareholder rights by 8.5 percent per year during this decade. Corporate governance is the system of rules, practices and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community. Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure. (Hermalin and Weisbach (1998, 2003)). Stock ownership of board members (Bhagat, Carey, and Elson (1999)), and whether the Chairman and CEO positions are occupied by the same or two different individuals (see Brickley, Coles, and Jarrell (1997)). Can a single board characteristic be as effective a measure of corporate governance as indices that consider 52 (as in Brown and Caylor), 24 (as in GIM) or other multiple measures of corporate charter provisions, and board characteristics? While, ultimately, this is an empirical question, on both economic and econometric grounds it is possible for a single board characteristic to be as effective a measure of corporate governance. Corporate boards have the power to make, or at least, ratify all important decisions including decisions about investment policy, management compensation policy, and board governance itself. It is plausible that board members with appropriate stock ownership will have the incentive to provide effective monitoring and oversight of important corporate decisions noted above; so the independence if directors or ownership can be a good proxy for overall corporate governance.

2.6. Discussion and Contributions

The idea of free cash flow initiated by Jensen (1986), and describe that free cash flow is the sum of the surplus funds available after profitable investments. According to the free cash flow hypothesis, managers are able to manipulate free cash flow under their control. As these managers do not want to go under threat of bankrupt, they are reluctant to pay out dividends or debt financing. The positive relation between abundance of cash flows and lack of good growth opportunities is often referred to Lehn and Poulsen (1989), Pindado and Miguel (2001) and Pindado and Torre (2009). Subsequently, the existence of a substantial level of free cash flow might lead managers to choose for viable investment policies. To conceal their projects counter-performance, managers may engage in aggressive earnings management practices (Chung et al., 2005); Chung et al., 2005b; Jaggi and Gul, 2006; Bukit and Iskandar, 2009; Rusmin et al., 2014).

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Similarly, they do not look favorably on using external capital, being unwilling to bear the scrutiny of lenders or shareholders. Excessive free cash flow in the hands of managers leads to overinvestment due to investment in projects with negative net present value (Jensen, 1986, Jensen and Meckling, 1976). In the event that funds are provided by capital markets; ample, detailed information needs to be shared with market participants and more these bring more questions that have to be answered by the managers. Rubin (1990) and Lang, Stulz, and Walkling (1991) argued that managers prefer to use any free cash flow remaining after investment negative-NPV projects to continue to invest in such projects rather than pay out dividends.

According to Christie and Zimmerman (1991), paying out dividends is helpful for reducing free cash flow in the hands of company managers as well as reducing agency cost. They found that, as a result, dividends help check managers and create a discipline mechanism without the direct intervention of shareholders. The reduction of free cash free cash flow in managers' control was found to reduce agency cost and raise company worth (Park & Jang, 2013). According to La Porta et al. (2000), overinvestment and personal expenditures are seen even in environments with stricter investor protections. Acquiring firms that are not feasible investments is also seen more frequently at firms with greater free cash flow (Opler, Pinkowitz, Stulz, & Williamson, 1999).

The findings of Rozeff (1982) and Easterbrook (1984) support the free cash flow hypothesis. According to these researchers, paying greater dividends can reduce firms' agency costs. As firms paying high dividends are financed more often by the market, they are subject to closer scrutiny. DeAngelo (2000) and La Porta et al. (2000) also reached similar conclusions. However, Denis et al. (1994) did not obtain results supporting this hypothesis.

Brush, Bromiley, and Hendrickx (2000) found that free cash flow negatively impacted growth while Titman et al. (2004) and Fairfield et al. (2003) found a much lower stock performance among firms with overinvestment problems. Similarly, Dechow et al. (2008) proposed that firms with excessive free cash flow had a lower future performance.

Lang et al. (1996) suggested that higher debt ratios reduced free cash flow at firms with low Tobin's Q ratios. Similar findings were obtained by Li and Cui, 2003, Byrd, 2010, Khan et al., 2012, Fatma, 2011 and Zhang (2009).

This study purpose is to explore the relationship of free cash flow with the performance of technology firm with R&D expenditures, and the role of corporate governance in the relationship. Data of 1348 US listed companies with R&D expenditures from 2009-2017 are used to empirically examine the hypothesizes.

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The former literature, mostly focus on the same period of free cash flow and its effect, however, maybe the effect is resulted from the previous factors. This study will focus on the different period of FCF and performance to compare, and I will restrict my research field in firms with R&D, since its nature decide that the high free cash flow may means low investment in R&D according to the free cash flow hypothesis, which is the core element to push the growth and development of this firms.

Moreover, this study can give an illustration that accounting information can be used not only to reflect the current condition of a firm but also to forecast the future performance of a company. and it can help investors to do a better investment decision, and the management to realize certain potential problems in their firm and therefore improve the future performance in an ex-ante fashion.

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3. Hypothesis development

3.1. Hypothesis 1

Free cash flow is a cash flow available for resource providers after paying all expenses and requirements of business which are necessary for keeping it into operating form. Proper management of working capital components enables the firms to hold excess free cash flows which can in turn be investment in profitable investments to generate profits for the firm. Cutting of costs has a significant effect on the free cash flow held by the firm; this permits the firm to have additional finances to take advantage of profitable investment projects that can yield higher returns. Free cash flow does not only impact on revenues and profitability of the firm but also the management of the balance sheet. If the firm fails to manage its net working capital properly then free cash flows might be lower than the net earnings of the firm.

Recent research by Hubbard (1998) shows that there is a significant positive relationship between free cash flows and profitability, an increase in the level of cash flow of a firm leads to a corresponding increase in profits of the firm. This is possible even when the firms have a low financial capacity after making acquisitions since they invest in non profitable investment projects (Carolyn, Carroll & Griffith, 2001).

Firms can decide to hold free cash flows for speculative purpose as they wait for a profitable investment that can promise better returns in future. The firm can also decide to invest in risk investments that have higher returns; these investments may later yield better returns which could be profitable to the firm. On the other hand, if poorly invested free cash flows can negatively impact on the profits of the firm if the firm engages in risk investments and end up losing (Griffith & Carroll, 2001).

Free cash flow is a commonly used proxy for the agency problem according to the former literature. According to La Porta et al. (2000), overinvestment and personal expenditures are seen even in environments with stricter investor protections. Agency theory predicts that the misalignment of interests between shareholders and managers could lead to agency problems, that is, managers engage in activities for their own benefits rather than the benefits of the firm’s shareholders (Jensen and Meckling 1976). Steven and al. (2003) have found on a sample of 552 companies that the yields, during the period of the announcement of the purchases of assets, are related negatively to the amount of FCF particularly for companies with low growth opportunities. Acquiring firms that are not feasible investments is also seen more frequently at firms with greater

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fact that the companies having a high level of FCF buy an asset for a price above its real economic value. Lang, Stulz, and walking (1991) show that companies with a high level of FCF and low growth opportunities have negative returns during the period of the announcement of the purchases. Zhou blow and Al (2012) conducted a study on a sample of Chinese companies for the period 2006-2010. They examined the relationship between the free cash flow and financial performance in order to optimize the financing decision for managers and investors. Their results showed that the free cash flow of the company is negatively correlated to the financial performance. Moreover, high free cash flow ratio might indicates ineffective use of cash, and fewer investment in R&D, so I predict that high current free cash flow is an indicator of low future performance in firms with research and development expenditures.

Hypothesis 1: High current free cash flow is an indicator of low future performance in technology firms with R&D expenditures.

3.2. Hypothesis 2&3

Based on these financial statements, it will be seen whether the performance of the company has good governance and effective (good corporate governance) and the governance of whether it can reduce the opportunistic behavior of management within the company (Cornett et all, 2008). The study concluded that an independent commissioner has positive effect but not significant to earnings management or profit management. Cornet et.al (2006). Institutional ownership has no significant effect on earnings management. The bigger the stake, the smaller the earnings management practices that occur. Sylvia Veronica N.P. Siddharta Sirregar and Main (2005), the proportion of independent directors and a significant negative effect on the income smoothing (earnings management) opportunities. Palestine (2006) and Nuryaman (2008) Companies with free cash flow (free cash flow) is high will have greater opportunities to make profit management, because the company indicated face greater agency problems (Chung et al, 2005). Free cash flow or free cash flow is defined as cash flow actually available for distribution to shareholders and creditors after the company invested in fixed assets and working capital needed to sustain the operations of the company. Brigham and Daves (2003).

Chang et al. (2015) carried out a study entitled “Corporate governance, product market competition and capital structure” and investigated the relationship between corporate governance and capital structure. In this research, they considered product market competition as a moderator variable in the relationship between corporate governance and capital structure. Their findings showed that when a company with poor corporate governance is present in an industry with high

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competitiveness, it has greater incentive to maximize the wealth of its shareholders and this leads to faster adjustment of capital structure.

The study is going to investigates the role of corporate governance in reducing the agency problem in high-technology firms. Strong corporate governance can mitigate the agency problem and restrain managers’ incentives to further their own interests at the expense of the shareholders (Shleifer and Vishny 1997). Prior research has examined the impact of a variety of corporate governance mechanisms on firm performance and managerial decision making (see Larcker, Richardson, and Tuna 2007 for a review). So, I predict that the relationship between the current free cash flow and future performance can be mitigated by strong corporate governance in high-technology firms.

Hypothesis 2: The negative relationship between the current free cash flow and future performance in technology firms with R&D expenditures will be mitigated by the board size. Hypothesis 3: The negative relationship between the current free cash flow and future performance in technology firms with R&D expenditures will be mitigated by the independence of directors.

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4. Research Design

4.1. Sample

The sample is U.S listed companies. The initial sample includes about 2000 companies with research and development expenditures. I Data are available through databases within the Wharton Research Data Services (WRDS) system to which the university subscribes. Company-year level accounting data for U.S. companies are available through the COMPUSTAT Fundamentals Annual database. Corporate governance data are from ISS Directors database. The sample period ranges from 2009-2017. This period also excludes the financial crisis period which happened in 2008 in order to eliminate the influence of the crisis. The sample includes 1348 US companies with R&D expenditures.

4.2. Independent Variables 4.2.1. Free Cash Flows (FCF)

Hackel, Livnat,m&Rai (2000) proposed following two explanations for free cash flows (1) the conventional definition is that the funds paid for company's investment are deducted from operating cash flow. (2) a newer formula for Free Cash Flow calculation equals to the addition of discretionary cash outlays (DCO) and discretionary capital expenditure (DCAPEX) to the traditional free cash flows FCF.; According to Poulsen and Lang free cash flows could be defined as operating net income before depreciation less corporate income tax, interest expenses, and cash dividends. The advantage of the definition was that it indicated how much the actual free cash flows were available for management to exercise. Richardson (2006) defined FCF as the net cash the firm earns from operating activities after making deduction from development costs; this cost is then added to R&D expenditures and finally investment expenditures in new projects is deducted from that. Another definition of FCF states that FCF is the cash acquired through firm’s operating activities deducted from cash components of investment (Zerniet al., 2010). Non-cash expenses after deducting the expenditures for property, working capital, plant, equipment and other capital assets plus after-tax cash from operations can be called as free cash flow for the firm (Copeland, 1995). Dechow and Ge (2006) said that cash flows from operations together with the cash flows from investment activities are in actual fact the free cash flows. Some studies have normalized free cash flow with sales while others have done so using total assets. This study uses the total asset to normalize free cash flow.

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18

FCF

_$

=

&'($)*+,$) -.,/$)'012$) 3012

4+567$

4.2.2. Corporate Governance:

Divide governance into weak and strong ones according to the following data.

1) Board size(Sbd): Talking about the board size and the firm performance, two distinct schools of thoughts can be mentioned. Lipton and Jensen argue that a smaller board size will contribute more to the success of a firm (Lipton and Lorsch, 1992; Jensen, 1993; Yermack, 1996). However, Pfeffer and Coles consider that a large board size will improve a firm’s performance (Pfeffer, 1972; Klein, 1998; Coles and ctg, 2008). These studies indicate that a large board will support and advise firm management more effectively because of a complex of business environment and an organizational culture (Klein, 1998). Moreover, a large board size will gather much more information. As a result, a large board size appears to be better for firm performance (Dalton and ctg, 1999).

Board Size is measured as the total number of directors on the board.

2) The Percentage of Independent Directors(Ind), Many empirical studies have agreed on the importance of independent directors to the success of a firm. For example, Elloumi and Gueyié (2001) concluded that firms with high ratio of independent directors in a board face less frequent financial pressure. In addition, when a business environment worsens, firms with many independent directors have had lower probability of filing for bankruptcy (Daily et al., 2003). As such, a research hypothesis is presented below. Moreover, Brickley et al. (1988) concluded that the board’s ownership is an encouragement for board members. This encouragement will help board members supervise management in a more efficient way. Consistent with this view, Jensen and Murphy (1990), Chung and Pruitt (1996) considered that, board’s ownership will improve firm’s performance. Mehran (1995) presented empirical evidence that there is a positive correlation between board ownership and firm’s performance.

The Percentage of Independent Directors is calculated as the number of outside directors divided by the total number of directors.

4.3. Dependent Variable 4.3.1. Firm Performance

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The firm’s success is basically explained by its performance over a certain period of time. Researchers have extended efforts to determine measures for the concept of performance as a crucial notion. Finding a measurement for the performance of the firm enables the comparison of performances over different time periods. Nevertheless, no specific measurement with the ability to measure every performance aspect has been proposed to date (Snow & Hrebiniak, 1980). Return on equity (ROE) are the most commonly adopted measures for corporate operating performance. According to Hutchinson and Gul (2004) and Mashayekhi and Bazazb (2008), accounting-based performance measures present the management actions outcome and are hence preferred over market-based measures when the relationship between corporate governance and firm performance is investigated. As a result, a company showing a positive performance through ROE, it indicates its achievement of prior planned high performance (Nuryanah & Islam, 2011). ROE are defined as follows, respectfully:

𝑅𝑂𝐸$ = 𝑁𝐼_$ 𝐸𝑞𝑢𝑖𝑡𝑦_$

4.4. Control Variables

According to literature, there are four control variables were chosen. 4.4.1. Control variable 1:

CEO⁄Chairman Separation(CEO-COB), an indicator variable that is equal to one if the CEO and the chairman of the board are not the same person and zero otherwise.

Hallock (1997) and Westphal and Khanna (2003) emphasize the role of networks among CEOs that serve on boards, and the adverse impact on the governance of such firms. Ex ante, there is no reason to believe that this variable will be correlated with firm performance.

4.4.2. Control variable 2:

Firm size, Demsetz stated that firm with larger size may produce higher value since more corporate resources are available to transformed into outputs.

𝑆𝑖𝑧𝑒$ = ln (𝑆𝑎𝑙𝑒𝑠$)

Ravenscraft (1983) and Amato and Wilder (1985) show that the explanatory power of a firm’s absolute size in determining its profitability is sensitive to the presence of such variables as its market share and market concentration. In line with the structure-conduct-performance paradigm, they instead find market share to be the key factor in explaining profitability.

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Leverage ratio, where DA denotes debt ratio and Debt total debt. To control the impact of systematic risk on market value of a firm.

𝐷𝐴_$ = 𝐷𝑒𝑏𝑡$ 𝐴𝑠𝑠𝑒𝑡$

The monitoring hypothesis states that debt can reduce the agency conflict by credit monitoring, especially by banks (Thomson & Coyen, 2012). By monitoring and controlling managerial behavior, creditors can reduce self-interested behavior of managers and, thus, increase firm performance. Several studies have indicated that bank loans can have a positive effect on firm performance (Degryse and Ongena, 2001; James, 1987; Lummer & McConnell,1989.

Growth$ =₄₊₅₆₇4+567U

UVW− 1

An alternative approach to growth and profit relationship, the ‘passive learning model’ of

Jovanovic (1982) predicts that the annual growth rate of a firm depends on the accuracy at which managers are able to predict the prices of products. The profit of each firm depends on its efficiency level. If firms discover that they are efficient, they grow and survive. Otherwise if firms that obtain consistently negative information they decline and eventually leave the market (Bhattacharjee, 2005).

4.5. Hypothesis models:

There are multiple models used to test performance in the literature.

Hypothesis 1: High current free cash flow is an indicator of low future performance in technology firms with R&D expenditures.

When test the relationship between free cash flow and low future performance I apply an extension model of George Yungchih Wang. (2010) in which adjust firms performance by considering their debt ratio, growth and firm size. Haitham Nobanee and Jaya Abraham (2017) test the the relationship among free cash flow, agency costs, and how they influence the profitability of

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insurance firms, in their model, ROE was used as a proxy for performance. The regression model is constructed as follow:

𝑅𝑂𝐸_$= 𝛽_[ + 𝛽_]𝐹𝐶𝐹_$)]+ 𝛽_`𝐶𝐸𝑂 − 𝐶𝐵𝑂_$+ 𝛽_b𝑆𝑖𝑧𝑒_$+ 𝛽_c𝐷𝐴_$+ 𝛽_d𝐺𝑟𝑜𝑤𝑡ℎ_$+𝜀_$ (1)

In the above equation, for any firm i and year t, ROE is the return of equity at the year t, free cash flow is a lag independent variable at t-1 time (one year before year t) and is scaled by average total assets. I additionally control for CEO⁄Chairman Separation, firm size and leverage ratio. If free cash flow predicts future firm performance as I hypothesize, it will reduce earnings and should therefore have lower return on equity. In this case, the coefficients (β_1) should be statistically significant. If the coefficient is negative, more free cash flow predicts lower firm performance in the future.

Hypothesis 2: The negative relationship between the current free cash flow and future performance in technology firms with R&D expenditures will be mitigated by the board size. The model for the influence of board size on the relationship between free cash flow and firm performance is based on Equation (1) and the model of (Pfeffer, 1972; Klein, 1998; Coles and ctg, 2008) by adding interaction term between free cash flow and board size. The regression model is constructed as follow:

𝑅𝑂𝐸_$ = 𝛽_[+ 𝛽_]𝐹𝐶𝐹_$)]+ 𝛽_`𝑆𝑏𝑑_$+ 𝛽_b𝐹𝐶𝐹_$)]𝑆𝑏𝑑_$+ 𝛽_c𝐶𝐸𝑂 − 𝐶𝐵𝑂_$+ 𝛽_d𝑆𝑖𝑧𝑒_$+

𝛽_l𝐷𝐴_$+ 𝛽_m𝐺𝑟𝑜𝑤𝑡ℎ_$+𝜀_$ (2)

Where sbd is board size at year t, FCF*Sbd is the interaction of free cash flow and board size at year t. Adding an interaction term to a model drastically changes the interpretation of all the coefficients. If there were no interaction term, β_1 would be interpreted as the unique effect of free cash flow on return of equity. But the interaction explains that the effect of free cash flow on firm performance is different for different values of board size. According to former literature, a large board will support and advise firm management more effectively because of a complex of business environment and an organizational culture (Klein, 1998). If the hypothesis is supported, the coefficient of interaction term should have a different sign with the coefficient free cash flow, which means the impact of free cash on the firm performance can be mitigated with the increase of board size.

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Hypothesis 3: The negative relationship between the current free cash flow and future performance in technology firms with R&D expenditures will be mitigated by the independence of directors.

The model for the influence of independence of directors on the relationship between free cash flow and firm performance is based on Equation (1) and the model of Elloumi and Gueyié (2001) ) by adding interaction term between free cash flow and board independence. The regression model is constructed as follow:

𝑅𝑂𝐸_$ = 𝛽_[+ 𝛽_]𝐹𝐶𝐹_$)]+ 𝛽_`𝐼𝑛𝑑_$+ 𝛽_b𝐹𝐶𝐹_$)]𝐼𝑛𝑑_$+ 𝛽_c𝐶𝐸𝑂 − 𝐶𝐵𝑂_$+ 𝛽_d𝑆𝑖𝑧𝑒_$+

𝛽_l𝐷𝐴_$+ 𝛽_m𝐺𝑟𝑜𝑤𝑡ℎ_$+𝜀_$ (3)

Where Ind is the percentage of independence of directors at year t, FCF*Ind is the interaction of free cash flow and the percentage of independence of directors at year t. Similar to the equation (2), the interaction can help explain that the effect of free cash flow on firm performance is different for different values of board size. According to former literature, there is a positive correlation between board ownership and firm’s performance. Mehran 1995). If the hypothesis is supported, the coefficient of interaction between free cash flow and board independence should have a different sign with the coefficient of free cash flow, which means the impact of free cash on the firm performance can be mitigated with the increase of board independence.

Moreover, this study can give an illustration that accounting information can be used not only to reflect the current condition of a firm but also to forecast the future performance of a company.

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5. Results and Analysis

The data collected are divided into five different industries which are finance, plantation, industrial products, properties and consumer goods. This study utilizes panel data regression for testing the hypothesis and the results indicated support the entire hypothesis as suggested. The findings point out that FCF as the independent variables has related significantly negative relationship with that firm’s performance,

5.1. Results

According to the results of the panel regression, a statistically significant, negative relation exists among free cash, firm performance and as well as corporate governance. In addition, total assets and free cash flow have a significant, positive correlation. Thus, the results support the free cash flow hypothesis. As the hypothesis suggests, dividend distribution and debt financing reduce free cash flow. In other words, firms with high dividend distribution or high debt ratios have a lower amount of free cash flow in the hands of managers.

Table 1. Descriptive statistics.

Variables Percentiles Min Max Average Median S.D Dependent variable ROE 100th -1.55 1.44 0.076 0.03 0.18559 25th 1.02 1.44 1.132 0.09 0.17432 75th -1.21 1.44 0.124 0.07 0.16324 Independent variables FCF 100th -2.52 2.79 0.006 0.05 0.25135 25th 0.98 2.79 1.242 1.35 0.22643 75th -1.97 2.79 0.134 0.52 0.24325 Sbd 100th 5 15 8.65 7 1.533 25th 11 15 12.50 12 1.498 75th 8 15 9.20 8 1.501 Ind 100th 0.20 0.60 0.36 0.3 0.0506

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25th 0.5 0.6 0.56 0.5 0.0502 75th 0.3 0.6 0.44 0.4 0.0504 Control variables CEO-CBO 100th 0.00 1.00 0.74 0.62 0.4387 25th 0.72 1.00 0.89 0.91 0.4356 75th 0.35 1.00 0.81 0.77 0.4452 Size 100th 16.52 24.29 21.21 20.97 1.1146 25th 21.32 24.29 23.58 23.26 1.1278 75th 18.97 24.29 22.02 21.03 1.1203 DA 100th 0.01 0.97 0.442 0.49 0.5203 25th 0.68 0.97 0.742 0.72 0.5312 75th 0.21 0.97 0.602 0.63 0.5219 Growth 100th -1.00 13.95 0.245 3.21 0.9751 25th 7 13.95 10.16 9.89 0.9865 75th -0.02 13.95 1.396 4.98 0.8798

Notes: The table provides summary statistics for the main variables for firm-year observations from fiscal years 2009–2017. It shows the minimum, maximum, median, and average for each variables and their standard deviation respectively. In order to provide a more clear picture of the distribution of those

variables, I also provide the describe information of 25th percentile and 75th percentile for each variable, the

percentiles are separated by descending order of value.

Table 2. Person correlation matrix.

ROE FCF Sbd Ind

CEO-CBO Size DA Growth

ROE 1

FCF -0.065* 1

Sbd 0.051 0.032 1

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CEO-CBO 0.010 0.031 0.081** -0.064* 1

Size 0.153*** 0.089*** 0.167** -0.063* 0.128** 1

DA -0.027 -0.005 -0.052 0.011 0.003 0.137** 1

Growth 0.141** -0.013 0.019 -0.007 0.026 0.063* 0.015 1

Notes: The table provides correlations for the main variables for firm-year observations from fiscal years 2006-2008.. All numbers are rounded up to third decimal place.

∗ ∗ ∗ indicate significance at the 1% level. ∗ ∗ indicate significance at the 5% level. ∗ indicate significance at the 10% level.

Table 3. The regression results

variables H1 H2 H3 β t β t β t Const. -0.563 -4.785*** -0.565 -4.795*** -0.559 -4.160*** FCF -0.040 -1.597** -0.041 -1.595** -0.038 -1.509** Sbd 0.05 1.187 Ind -0.064 -0.558 FCF*Sbd 0.133 1.661* FCF*Ind 0.009 1.449 CEO-COB -0.009 -0.668 -0.011 -0.789 -0.009 -0.665 Size 0.027 5.008*** 0.027 5.029*** 0.028 4.977*** DA 0.002 0.142 0.003 0.243 0.002 0.162 Growth 0.024 4.168*** 0.025 4.174*** 0.024 4.145***

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F 3.55*** 3.64*** 3.37***

Adj. R square 0.154 0.165 0.160

Notes: This table examines firm performance and reports the results of the relevant OLS regressions. The sample consists of firm-year observations from fiscal years 2009–2017, where the dependent variable is ROE of year t.. All numbers are rounded up to third decimal place. Variable definitions are shown in the Appendix. 

∗ ∗ ∗ indicate significance at the 1% level.  ∗ ∗ indicate significance at the 5% level.   ∗ indicate significance at the 10% level.

5.2. Analysis

5.2.1. Correlation analysis:

Table 2 shows the Person correlation results, the correlations of each variables included. As I supposed, the correlation coefficient of FCF and ROE is negative, -0.065, that means more free cash result in low performance, maybe due to management’s self-interest behavior. The size of firms and the ROE has positive positive correlation coefficient, 0.153, that means the bigger the company, the better the performance, partly due to the better growth ability, which also support my former assumption. Other statistically significant correlation exit between CEO/chairman separation and board size, board independence, the correlation coefficient between CEO/chairman separation and board size is positive, 0.081, and the correlation coefficient between CEO/chairman separation and board independence is negative, -0.064. The board size and board independence has a negative relationship, as we can see from the table, the coefficient of correlation between board size and board independence is -0.515. Apart from the dependent variable, the firm size has influence on all the independent variables, because the coefficient of correlations of firm size and other independent variables are all statistically significant. The firm size also can influence the control variables, because the coefficient of correlations between firm size and CEO/chairman separation, debt ratio, and growth are all statistically significant. Among all the relationships of firm size with all the other variables, only the relationship of firm size and board independence is negative. Last, the coefficient of correlations between control variable growth and dependent variable is significantly positive, 0.141, that means firms with higher growth rate will result in higher return of equity, and better firm performance.

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5.2.2. Regression Analysis:

Table 3 shows the regression results, as it shows, the F statistics for all three hypothesizes are significant, which means for each hypothesis, the set of independent variables, as a group, can explains the variation in the independent variables and control variables. In other words, we can interpret from t-tests that for all the hypothesis, at 1% level of significance, at least one of the independent variables or control variables in the regression model makes a significant contribution to the explanation of the dependent variable for each hypothesis. From the adjusted R square, we can see, for hypothesis 1, all the dependent variables and control variables together explain 15.4% of the variation in return of equity; for hypothesis 2, all the dependent variables and control variables together explain 16.5% of the variation in return of equity; for hypothesis 3, all the dependent variables and control variables together explain 16% of the variation in return of equity. Then we need to look further on the coefficient of each dependent variables and their related t statistics to analysis the impact of dependent variables on the dependent variables in each hypothesis.

For the Hypothesis 1:

It tests the impact of free cash flow on the performance of firms with R&D expenditures. The coefficient of free cash flow is -0.040, and the t statistic is -1.597, which means the coefficient of free cash flow is statistically significant at the 5% level of significance. As I supposed before, free cash flow has a negative impact on firm performance, so hypothesis 1 is supported. From the regression result of model 1, we can see that the control variables: size and growth both have positive impact on firm performance, because they have positive coefficient and statistically significant at the 1% level of significance.

It tests the size of board’s impact on the relationship of free cash flow and firm performance. The interaction term coefficient is 0.013, and accordingly t statistics is 1.661, which means the coefficient of interaction term between free cash flow and board size is statistically significant at 5% level of significance. That is to say the negative relationship between the current free cash flow and future performance in firms with R&D expenditures will be mitigated by the board size. The interaction effect is depicted as the below graph. As we can see negative impact of free cash flow on ROE is slighted improved under the condition with board size of high value. In conclusion Hypothesis 2 is supported. In consistent with the model 1, we can see from the regression results of model 2 that that the control variables: size and growth both have positive impact on firm

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performance, because they have positive coefficient and statistically significant at the 1% level of significance.

It tests the impact of the independence of directors on the relationship of free cash flow and performance of firm with R&D expenditure. The coefficient of interaction term between the independence of directors and free cash flow is 0.009, which is slightly positive. However, with the t statistics of 1.449, the coefficient isn’t statistically significant, so hypothesis 3 isn’t supported. In consistent with the model 1 and model 2, we can see from the regression results of model 3 that that the control variables: size and growth both still have positive impact on the performance of firm with R&D expenditures, because they have positive coefficient and statistically significant at the 1% level of significance.

Overall, what we can learn from the regression results is that hypothesis 1 and hypothesis 2 are supported, however, hypothesis 3 isn’t supported.

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6. Conclusion

In this study, data of 1348 US listed companies with R&D expenditures from 2009-2017 are used to empirically examine the impact of free cash flow on the performance of firms with R&D expenditures and if corporate governance can influence the relationship between firm performance and free cash flow.

As the theories put forth by Jensen and Meckling (1976) and Fama and Jensen (1983): “the holding of free cash flow might lead to self-interest behavior of the management, and therefore it has a negative impact on the firm performance.” The result supports this argument, and shows that the negative impact of free cash flow also exists in technology firms R&D expenditures. That means the free cash flow hypothesis and agency theory stand in the setting of technology firm with demand of research and development.

However, the former literature also argue that effective corporate governance can improve firm performance. By taking the impact of corporate governance into account, board size and board independence are chosen as proxies for corporate governance to examine the impact on the negative relationship of free cash flow and performance of firms with R&D expenditures, and interact term is used to give a better understanding of these relationships. The result shows that a larger board size can moderate the negative impact of free cash flow on performance of firms with R&D expenditures, that probably because a large board size will gather much more information. As a result, a large board size appears to be better for firm performance (Dalton and ctg, 1999). However, the impact about the independence of directors is not statistically significant.

In conclusion, in this study about the impact of current free cash flow on the future performance in the setting of technology firms with R&D expenditures, we can see that high free cash flow do have a negative impact on the future performance due to the agency problems, and this effect can be reduced by enlarging the size of board in the technology firms.

There several contributions need to be mentioned. First, this paper is the first empirical test of the impact of free cash flow on the firm performance in the setting of technology firm with R&D expenditures. It appears extremely meaningful in the current period, since technology is the first source of the social development. Second, this paper use drag variable to test the current free cash flow on the future performance of technology firm with R&D expenditures, so the result is more powerful as an enlightening example of accounting fundamentals being used as an indicator of future performance, as an additional function apart from its main purpose to reflect historical and current firm status.

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Several important implications are identified. First, the results of regression show that apart from the free cash flow has negative impact on the future performance of firms with R&D expenditures, and the broad size can mitigate the relationship, the control variables such as firm size and firm growth can also improve firm performance. Further study can combine these two factors with free cash flow to test their impact on the relationship of free cash flow and firm performance. Second, the result of this study worth arousing the attention of regulatory bodies, because effective regulations can improve the negative impact of free cash flow by setting good corporate governance environment and other policy such as dividend distribution can be applied to align the interests of shareholders with the management, thereby reducing the potential agency problems. The limitations of this study can’t be avoided as other studies. First, because this study and the is test in a specific setting, which is the technology firms with R&D expenditures from 2009-2017, the result isn’t supported to be generalized to other firms and other period. More evidences need to be acquired for those kind of generalization. Second, the study only use to proxies: the size of broad, and independence of the directors to test the impact of corporate governance, the impact of other factors can’t eliminated, and more variables can be added to test the impact in further research.

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