The Impact of Free Cash Flow in Technology Companies with
R&D expenditures
Name: Yu Zhang
Student number: 11845929
Thesis supervisor: Alexandros Sikalidis Date: August 19th, 2018
Word count: 12518
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam
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.
Abstract
The research purpose is to examine the impact of free cash flow (FCF) on the performance of technology companies in US, and also test the impact of corporate governance on this relationship. This research used archival method to do empirical test. US listed technology companies are used as the test samples and research and development (R&D) expenditures are used to identify technology enterprises.
The result shows that consistent with former literature, FCF can be an indicator of poor performance in the setting of US listed technology companies, and this negative relationship is tested to be alleviated by strong corporate governance, such as large board size. This study supports the free cash flow and agency theory by providing empirical examples in the technology field and extend those theories by the combination of corporate governance. The multi-interaction among FCF, firm performance and corporate governance of the technology companies is presented in this study.
Key words: free cash flow, firm performance, corporate governance, agency problems, agency cost theory
Contents
1. Introduction ... 5
2. Literature review and contributions ... 7
2.1. Free cash flow theory ... 6
2.2. Agency cost theory ... 8
2.3. Theoretical explanation of the relationship between FCF and firm performance ... 12
2.4. Corporate governance and company performance ... 14
2.5. Discussions and contributions ... 16
3. Hypothesis development ... 18 3.1. Hypothesis 1 ... 18 3.2. Hypothesis 2&3 ... 19 4. Research Design ... 20 4.1. Sample ... 22 4.2. Independent Variables ... 22 4.3. Dependent Variable ... 22 4.4. Control Variables ... 22 4.5. Hypothesis Models ... 23 5. Empirical Findings ... 26 5.1. Descriptive Statistics ... 26
5.2. Pearson correlation analysis ... 28
5.3. Regression Analysis ... 29
6. Conclusions and Suggestions ... 33
6.1. Conclusions ... 33
6.2. Suggestions ... 34
1. Introduction
This paper use a sample of US listed companies with research and development expenditures to test whether and how free cash flows (Free Cash Flow, referred to as FCF) and corporate governance impact on the performance of technology enterprises.
As the pace of global technological advancement continues to accelerate, if enterprises want to occupy an advantageous position in the competition, they must cultivate independent innovation and core competitiveness, strengthen R&D investment, and promote long-term growth. How to improve innovation and efficiency is directly related to economic transformation and production. Nowadays, policy makers are paying great attention on promoting enterprises to increase innovation investment and improve efficiency. R&D investment is a key input to improve the level of innovation in enterprises, and an important driver of sustainable economic growth in the real economy. Continuous research and development activities can effectively promote to achieve sustainable growth, enhance the long-term competitiveness of enterprises. As we known, research and development activities require a lot of financial support, and R&D investment recovery is long-term process. It has brought tremendous pressure on corporate capital management. At the same time, the information problem and risk control requirements make it difficult for companies to obtain external sufficient funds. Ample free cash flow is driving companies to conduct research and development projects, because the enterprises have to meet research and development investment needs, they rely too much on internal funds, and make sub-optimal investment decisions.
This research studies the relationship among FCF, firm performance and corporate governance and has the following findings:
1. FCF exists in most listed US technology firms, but it is not properly utilized due to the existence of agency problems, which will have a negative impact on the performance of technology enterprises with R&D expenditures.
2. Corporate governance has played a role in preventing management from abusing free cash flow, infringing on shareholders' interests, and damaging corporate performance. The larger the size of BOD (the board of directors), the more beneficial it is to mitigate the damage caused by excessive FCF to the performance of technology companies.
The structure of this study is organized as follows:
Section 2, Literature review and contributions. This part including free cash flow theory, agency cost theory, and their relationships with firm performance.
Section 3, Hypothesis Development. This part demonstrates how the hypothesizes are proposed. Section 4, Research Design. This part is mainly for the empirical study of the conclusions of research.
Section 5, Empirical findings. This part mainly uses empirical methods to test the hypothesis and analyze the results.
Section 6, Conclusion and suggestions. This part mainly concludes the findings, analyze the contributions, implications and limitations, also provides with suggestions.
2. Literature review and contributions
2.1 Free cash flow theory
2.1.1 General Theory of Free Cash Flow
In 1986, Michael Jensen (1986) did some in-depth research, and proposed FCF theory. Once the theory of FCF has been proposed, scholars from all over the world began to conducted extensive and in-depth research on FCF. However, for the meaning of "FCF”, various scholars in the world have different views and understandings, and there are some differences in the expression of FCF. There are also many calculation methods, and the results are different. There are also many names, such as: surplus cash flow, excess cash flow, disposable cash flow, distributable cash flow and so on. However, these definitions all hold the belief that free cash flow does not affect the company’s normal production management and the long-term development, the company can provide maximum cash flow to shareholders.
2.1.2 Proposal of free cash flow
Franco Modigliani and Mertor Miller (1958) are the first scholars to propose the concept of FCF. They had some useful discussions about the concept of FCF. In 1958, they proposed the name of MM theory, in-depth discussion on the company's capital structure, corporate goals and other issues, and re-interpretation of corporate goals and a preliminary analysis of free cash flow. Thereafter, in 1961, they again studied the value of the company, suggested that it was equivalent to the value of other assets, and also depends on the creation of cash flow in the next few periods. They used the built MM enterprise value assessment formula to assess the company's overall value. In the middle and late last century, Northwestern University professor Alfred Rappaport (1986) and Jensen (1986) did an in-depth and extensive study on free cash flow, the concept of FCF is discussed and proposed more completely. They defined what is FCF and this concept was widely adopted in corporate financial accounting practices from then on. Generally speaking, the free cash flow is created and produced by the company, which satisfies the remaining needs of the company after reinvestment needs. This part of the remaining cash flow is the largest amount that a company can distribute to shareholders through dividends, etc. The amount of cash, after distribution, can increase the interests of shareholders, but does not harm the company's long-term development.
and Jensen (1986), Rappaport (1986) built the famous Porter value evaluation model, and put forward the theory of company value evaluation. He not only pays attention to theoretical research, but also pays attention to practice and advocates practice. He founded ALCAR and put his value assessment model and its value assessment theory into practice. He advocated the combination of theory and practice. In his model, Rappaport believes that sales and sales growth, marginal operating profit, new fixed assets, the increase in production investment, new working capital and capital costs are five important factors driving the company's value growth. At the same time, these factors can also be used to predict the company's cash inflows and outflows. Due to the production and operation of the company activities create and generate cash inflows, which are cash flows after the company pays taxes. The business activities of an enterprise need to increase the investment in fixed assets, working capital, and management funds. Therefore, FCF is the reduction cash flow of investment and working capital, management funds after deducting the tax paid, discounted at a discount rate. Such free cash stream, we call it the company's FCF. And the company value is discounted value of FCF.
Scholar Rappapor (1986), Tom Copeland et al. (1990), Bradford Cornell Professor (1993), Aswath Damodaran (1996) and K. S. Hackel (1996) explains the meaning of free cash flow in their own ways. Table 2-1 lists the meaning of FCF for each scholar. The elaboration and calculation methods are summarized.
Table 2-1:
Scholars Calculation Elaboration
Rappapor t
𝐹𝐶𝐹#= 𝑀#&'∗ 1 + 𝑟# 𝑄#∗ 1 − 𝑆# − (𝑀0
− 𝑀#&')(𝑇#− 𝑂#)
Among them, FCF represents free cash flow; M indicates annual sales; r represents the annual growth rate of sales; Q represents the sales profit rate; S represents the income tax rate; T represents an additional fixed amount of net investment in assets for each $1 increase in sales; O represents the amount of capital investment required to be pursued for a $1 increase in sales; (𝑀0−
𝑀#&')(𝑇#− 𝑂#)) indicates the amount of
reinvestment.
FCF is a discounted value minus the increase cash flow on investment of fixed assets, working capital, management funds, and deducting the tax paid.
Tom Copeland
FCF = net operating profit after tax + amortization and depreciation- working capital expenditure - capital increase
FCF equals after-tax net operating profit adding other non-cash expenses, depreciation and amortization and then minus the increase in working capital and the capital investment in equipment, raw materials, etc.
Bradford Cornell
FCF = (operating profit + dividends + interest income) × (1 - income tax rate) + deferred tax increase + depreciation - capital expenditure - working capital
increase
FCF is the difference of cash inflows generated by the company and all expenditures.
Aswath Damodar an
FCF = pre-tax profit × (1-Income tax rate) + depreciation - capital expenditure - working capital increase
Similar to Bradford Cornell
K. S. Hackel
FCF = net cash flow from operating activities + other expenditures- capital expenditures
K. S. Hackel more mainly took into account that there is the possibility of company management exists the problem of “abuse of free cash flow”.
From the various statements made by many scholars on the definition and calculation of FCF, although there are a few differences, but we can still derive some common characteristics about the concept of FCF:
(l) FCF should be calculated after taking into account the company’s continuing operations or the necessary growth in cash demand. The free cash flow, which is approximately equivalent to operating cash flow minus the necessary capitalized cash outlays;
(2) As a kind of cash “surplus”, FCF is the company’s implementation of debt service and distribution of cash dividends. It is the embodiment of corporate value;
(3) The existing references do not have an absolute unity for the definition of FCF and the description of the calculation method.
2.2 Agency cost theory
2.2.1 Information Asymmetry Theory
The theory of information asymmetry was introduced in 1970 when scholars studied the information difference in the second-hand car market and then was widely used in the field of economics. Information asymmetry theory refers to that in the market economy, because of the different ability and cost of obtaining information, the quality and quantity of information that people are able to gain are different. The people with plenty of accurate information are in a favorable position in the transaction process. They conceal the information they have, so that the interests of the people with poor information or lack of information are harmed and those people are put at a disadvantage position. Information asymmetry can cause adverse selection and moral hazard as well.
1. Adverse selection refers to the expulsion of goods with high quality due to inferior goods promoted by information asymmetry among the seller and buyers and the decline in market prices. This phenomenon leads to the decline in the average quality of market trading products. Adverse selection will lead to low efficiency of resources allocation.
2. Moral hazard refers to the fact that one party in the trading activity pursues its own interests and harms the interests of others. Information asymmetry seriously affects the company's investment efficiency. The information asymmetry mainly exists between the company and external creditors, shareholders and operators, internal shareholders and external shareholders. When the company is financing, the external creditors will have adverse selection because they are in an information disadvantage position. Because of the information asymmetry that exists among the shareholders and the managers, it is easy to cause moral hazard.
2.2.2 Proposal of agency costs
Agent problems exist extensively in principal-agent relationships, when the targets of agents and principals are inconsistent and when the supervision of the individual is weak, some actions of the agent will damage the interests of principal. Such kind of behavior can cause agency problem. Due to the information asymmetry is difficult to eliminate, so the agent is in a position where can take advantage of the transaction when making decisions and uses his own information. At the same time, the limited amount of transaction information makes the client’s supervision of the agent not in time. The agent is more motivated to make decisions by personal interest to damage the interests of the client.
The academic research has accumulated a lot of analysis on the issue of agency costs, but the company's agency problem has not been favored by scholars. As the first person to study the agency problem, Jensen and Meckling formally proposed this concept in their article "Corporate Theory: Management Behavior, Agency Cost and Ownership Structure". They propose shareholders based on the separation of two powers. There must be a problem of agency costs between managers. Although the shareholders have the ownership of the company, for the sake of specialization, some management rights are entrusted to the managers for execution. This is the agency relationship.
As an economic individual, both shareholders and managers will make decisions based on their own interests. Shareholders need to supervise the behavior of managers in order to protect their own interests from being harmed. During the process of supervision, there will be supervision costs. In addition, managers also need to make guarantees to ensure that they don’t make mistakes in decision-making. Even if there is such kind measure, the conflict of interest between the two can not be completely eliminated, the loss of shareholders' interests is difficult to be avoided, and the part of the loss lost by shareholders is also a component of agency costs, which is the "residual loss." Therefore, agency costs consist of supervisory costs and residual losses. It is not difficult to
see that the origin of agency costs is the lack of trust between the two parties, and this unbelief also greatly increases transaction costs.
2.2.3 Theory of Agency Cost of equity
Jensen and Meckling (1976) put forward a lot of new ideas about the agency cost of equity built upon the predecessor theory. They believe when a company has one and only one owner and the day-to-day operations are all dependent on the owner's decision-making, any decision they made is to maximize the benefits of the managers. After a period of scale development, there is a shortage of internal funds, and external financing must be introduced. If you choose a lower-cost equity financing, it will lead to conflicts of interest between internal and external stakeholders. When managers work harder to run a business, he makes a lot of effort, but the rewards are limited. In contrast, if you increase your on-the-job spending, you will enjoy the full cost of the part. Therefore, the higher the number of managers holding shares, the more diligent the managers are in managing the company; on the contrary, the lower the shareholding ratio, the less effort and the motivation. The division of agency costs from the perspective of financing can be classified as equity generation costs and debt agency costs. Both types of agency costs are due to moral hazard such as managerial on-the-job consumption and blind investment. The former exists in the principal-agent relationship among the managers and the shareholders in the equity financing, while the latter appears in the debt financing.
2.2.4 The Impact of FCF on agency costs
The concept of FCF proposed by Jensen is actually based on the relevant theory of economics. His research focuses on whether the disposal of FCF is in the interest of shareholders and whether agency costs are generated. The conflict of interest between the two parties in the principal-agent relationship shall exist. To reduce the conflict is in the way of contract. The cost occurs during the contract formulation process and the part of the cost that exceeds the revenue at the time of execution are the agency costs. As long as the entrusted relationship exists, it is possible to generate agency costs. In the decision to dispose of FCF, the company's management, as the actual controller, is unwilling to return FCF to shareholders, but prefers to use the company's FCF for the following several aspects:
First, expand the scale of the enterprise and build a business empire. Shriver and Vishny (1998) confirmed this in their research.
Second, the in-service consumption of the manager during his or her employment, both material and non-material. Jensen and Maclean have confirmed this reason.
Third, it is used for diversified mergers and acquisitions. The empirical study by Summers, Sreef and Wesley (1990) also supports this claim.
Fourth, fund transfer according to personal preferences and interests, and the flow of such funds is completely inefficient. Related studies include Jensen and Maclean (1976), Lamont (1997), Berger and Hahn (2003).
These decisions of managers are not in line with the interests of shareholders, which is the manifestation for the agency costs of FCF.
For the sake of effectively reduce agency costs, we must explore the causes of agency costs for FCF. The generation of agency costs is first influenced by managers. Managers are constantly pursuing the maximization of their own interests during their tenure, and this goal will affect their disposal of cash flow. When there is a residual cash flow in the enterprise, many potential risks can be saved in the fund raising process. Because managers don’t have to worry about the source of funds, they can also avoid being creditors, and circumvented the adverse effects of financing failure. Therefore, in the consideration of whether to retain free cash flow, managers should start with their own needs, rather than maximize the interests of shareholders. This part of the funds is actually controlled by the manager, and its disposal decisions are not supervised by the creditors. It is easier for the manager to make this part of the cash flow to be used in investment activities where expected returns are much smaller than the investment cost. These actions reduce the value of the company and damage the interests of shareholders. On the other hand, managers also tend to use this part of the cash to expand the actual control, in order to increase the power, and also to use it privately. For on-the-job consumption, such behavior is not conducive to the long-term growth of the company.
Also, managers are not completely rational economic people. Even if the company's managers have the same interests as the shareholders, the economically assumed fully rational economic man exists only in the ideal world. Usually, pessimistic managers will over-amplify the uncertainty of future cash expenditures in decision-making of risk management. In order to avoid such risks, they will accumulate too much FCF and reduce the profitability of available assets. Besides, part of the retained free cash flow might stimulate investment for overly optimistic managers. The existence of cash flow encourages managers to choose projects whose true net present value is likely to be negative. Last, the management performance evaluation plan at this stage is not perfect. In actual operation, the reputation and material rewards that professional managers can obtain usually
increase with the expansion of the scale of the enterprise. Such performance evaluation programs encourage managers to conduct irrational investment to obtain super-scale development of enterprises, and thereby obtaining a performance evaluation that is more conducive to private interests. At the same time, due to the imperfect performance evaluation program, the salary system can not fully meet the actual needs of managers. When the company retains a certain amount of FCF, the possibility of managers using their powers to facilitate their own personal gains is greatly increased.
The causes of agency costs for free cash flow should be attributed to conflicts of interest among shareholders, creditors and company management. Shareholders hope to increase the intensity of the distribution, creditors hope to repay the principal on time and even pay in advance, but the management has done its best to keep this part of the cash flow remaining in the enterprise. When the level of FCF in the enterprises surges, the conflict between the three will become more intense, and the problem of agency costs will become more serious.
2.3 Theoretical Explanation of the Relationship between FCF and Firm Performance
According to the above analysis, it is known that the FCF is the embodiment of the company's previous operating results, and the use of FCF is a concentrated reflection of the company's financial policy and financial goals. This section will start with the influencing factors of company performance, analyze the role and value of FCF in the company's performance evaluation, and explain that FCF is indeed a financial indicator that can comprehensively reflect the performance of the company, and then find the relationship between FCF and the performance of companies.
2.3.1 Factors related with company performance
As a constitution of the social economy, the operational process of an enterprise must be influenced by many factors, such as external and internal environment. Correspondingly, the business performance of the enterprise is also the result of comprehensive effects of various factors. Both the normative and empirical studies have confirmed that.
In terms of the outside world, the external environment includes political, economic, cultural, legal, and micro-level competitors, suppliers, customers, etc., therefore, the international and domestic economic situation, the country's industrial development policies, the overall development trend of the industry and the intensity of competition in the market will affect the business performance in the companies.
From the perspective of the company itself, the internal environment includes the organizational structure, organizational elements, and business operations of the enterprise, management model,
the company’s governance structure, the shareholders’ meeting and management configuration, the company's equity concentration, as well as the company's financial management decisions, such as capital structure, financing, investment, and dividend distribution policies, can have a significant influence on companies’ performance.
In addition, some scholars have noticed that certain special development periods or some incidents may also affect the business industry performance.
In short, the factors affecting the performance of the company are multi-faceted, but only for the company itself, its performance is majorly influenced by the impact of corporate governance and financial management decisions, namely corporate governance structureàfinancial decision-makingàcompany performance.
2.3.2 Value of FCF and corporate governance in company performance evaluation
At present, the goal of maximizing shareholder wealth or maximizing corporate value has been widely recognized. The realization of this goal requires enterprises to conduct the main business while maintaining and improving the existing capital growth capacity. And to have gains from other business activities that can be used to distribute to shareholders are the largest. FCF is the part that can be utilized to repay debts and also be used as a part to distribute to shareholders after the company’s continuing operations and the necessary cash flow requirements for investment growth are taken into account. It can be said that the essential requirement of the concept of FCF is consistent with the target of financial management in a firm. The role and value of FCF in corporate performance evaluation is mainly reflected in its close relationship with corporate governance structure and financial decision-making.
1. The integration of FCF and corporate governance. Free cash flow is not only a financial issue linked to the production and operation process, but also a financial stratification management issue related to the corporate governance. The generation of FCF is by no means a single-level mission, but a production of the company's overall cooperation and efforts. Through the reasonable decomposition of the free cash flow generation process, the financial objectives and job responsibilities at all levels in the corporate governance structure can be clarified, and the pertinence and effectiveness of the company's internal financial decisions can be improved. This is not only the basic premise of ensuring clear authorization and clear responsibilities of the financial system based on corporate governance, but also the unique function of the principle of FCF for corporate governance and financial stratification management.
2. The link between FCF and corporate management decisions. FCF is not only a basic element of financial goals, but also a comprehensive element related to corporate investment, financing and dividend distribution strategies. FCF is served as a bridge and link between financial objectives and management processes. FCF is the residual cash flow that an enterprise can obtain through normal production and operation activities. For those companies with positive free cash flow, they can adjust the the scale of investment, the level of leverage and dividend distribution policy to satisfy their own needs, and link the core issues of these financial management to make overall plans.
2.3.3 Relationship between FCF and company performance
FCF is not the cash invested by investors, and it is difficult to be bound and supervised by external capital markets. When the management of the company holds such unrestricted cash flow in a large amount, the agency cost problem is very easy to occur, which is manifested by the manager's two ways of using free cash flow: the first way is to use FCF for personal purposes, such as increasing on-the-job allowances, subsidies, and increasing administrative expenses; the second way is to use FCF for enterprises to carry out investment activities that are inefficient or even detrimental to the efficiency of the enterprise. Through these investments, the scale of the company has expanded rapidly, and the resources that managers can control are increasing. Just as “unconstrained politics tends to lead to corruption, and an unconstrained economy can easily lead to inefficiency”, the agency cost of FCF is obviously not conducive to the effective governance of the company, leading to the decline of corporate performance and the loss of shareholder wealth.
2.4 Corporate governance and company performance
The research on modern corporate governance can be regarded that it is derived from the ownership-control theory proposed by Berle(1932). After then, Jensen(1976) analyzed the company's shareholding structure from the perspective of agency cost, and initiated the research on managerial ownership of corporate governance. With the deep research, the theory of stakeholders (Freeman, 1984) and the theory of super-property rights (Tittenbrun 1996) have emerged, people's understanding of corporate governance is getting more and more thorough. Mckinsey (2002) pointed out that desirable corporate governance can encourage the BOD and management to try their best to achieve the target of companies, which is to maximize the value of enterprise, as well as provide effective strategic guidance and supervision so that companies can effectively use resources to maintain long-term stable growth while corporate governance creates
value for companies. For companies with desirable corporate governance, a higher premium is usually provided by investors.
In the former related literature, great part of the research about corporate governance and corporate value focuses on the impact of a particular aspect of corporate governance on corporate performance. For example, studying the connection between the ownership structure with corporate performance (Himmelber, Hubbard and Palia, 1999; Mock, Shleifer and Vishny, 1988); relationship between board structure and company value (Agrawal et al., 1996; Hermalin et al., 2003); The impact of the plan on company value (Abowd et al., 1999; Bebchuck, Fried and Walker, 2002) and more. In recent years, a series of studies have been conducted to focus on the correlation among the corporate governance and corporate performance and enterprise value, mainly to establish a “Corporate Governance Composite Index” to more comprehensively and systematically examine the level of governance versus business performance and market value. The logic behind this approach is that the overall investigation is better than focusing on only certain parts.
Gompers and el (2003) first established a “Governance Index”, that is composed of 24 indicators related to the rights of shareholders and company takeover measures. After collecting the data of listed companies in the US in the 1990s, they conducted a regression analysis on the governance index and the company's profitability and sustained growth performance. The results show that the better the shareholders' rights protection, the higher of market value, the stronger profitability, the faster sales growth rate of products and the lower expenditures of capital the companies tend to have. Klapper et al.(2003) conducted a study of 374 companies in 14 countries and found that the CLSA in Asia is positively correlated with the company's market capitalization and return on assets. Durnev and Kim (2005) selected samples of 859 large companies in 27 countries, using the Asian CLSA governance index (C-A) and information disclosure scores, and found that companies with higher corporate governance indices are more easily to show better performance. Specialized research has established a “Corporate Governance Index” based on the listed companies in Russia (Black, 2001) and South Korea (Black, 2006). The study found that the corporate governance indices of the two countries are positively correlated with the market value.
However, some studies have found that corporate governance is not relevant to market performance. For example, Patterson's (2000) empirical study shows that a good corporate governance structure does not necessarily lead to better corporate market performance; Black (2001) proves that the correlation exists among corporate governance improvement and its stock price is extremely weak by studying the US market. Bhagatetal (2000) argues that the connection
of equity concentration with company value is not significant. Gillanetal (2003) did not find a significant relationship exist in the US market-to-book ratio with corporate governance; Durnev and Kim (2005) also considered that corporate governance is not necessarily related with its market performance after studying the stock price and governance level in emerging markets.
2.5 Discussions and Contributions
The main innovations of this paper are as follows:
1. The research provides new insight for investment evaluation. For corporate investors, when making investment decisions, evaluating corporate performance, and analyzing corporate value, in addition to using traditional financial indicators based on profit or cash flow statements, it should also pay attention to its free cash flow indicators, so as to the profitability and cash-capture ability of the company's main business, sustainable operation ability and subsequent development and profitability to make a comprehensive evaluation of capabilities.
2. The research perspective is novel. This paper breaks through the limitations of the previous research on the performance of the company and only pays attention to the profit indicators and the cash flow indicators of the operating activities. The concept of promoting free cash flow is practiced in US. Application and comprehensive, objective evaluation of the performance of listed companies in US have important practical significance.
3. The research method is novel. Based on relevant theories, this paper uses empirical analysis methods to propose hypotheses, select samples, construct models, conduct regression tests and analysis, and study the relationship between FCF of US listed companies and company performance.
4. This study is also the first research based on the sample of technology enterprises with R&D expenditures in US to study the impact of FCF.
3. Hypothesis development
3.1. Hypothesis 1
FCF refers to the portion of cash flow generated after the company's daily production and operation activities, which meets the funds requirements for all projects with a NPV greater than zero. Under the business model of the separation of the two powers of modern enterprises, due to information asymmetry, inconsistent interests and incomplete contracts, the operators often operate and manage the enterprises against the will of the owners in order to satisfy the private interests. The agency problem arises. If the management holds free cash flow, it will over-invest and build a “business empire”, which will aggravate the agency problem, exacerbate the contradiction between shareholders and management, and ultimately have a negative impact on the enterprises’ performance to a certain extent.
In recent years, scholars have used FCF as an entry point to do research on the relationship between FCF and the enterprises’ performance. Denis (1994) verifies the relationship between FCF and investment opportunities from the perspective of capital expenditure. The results show that when the company has residual FCF, the enterprise operator will not only increase the NPV of the future. Investment in negative projects, and will increase spending on on-the-job consumption. Kaplan and Zingales (1997) pointed out that in the case of weak external supervision and a large amount of FCF within the enterprise, the management of the company is likely to waste corporate funds after the effective investment, thus damaging the value of the enterprise. Harford (1999) analyzed and compared 487 M&A cases and found that the more FCF the company has, the more likely it is to conduct inefficient diversified mergers and acquisitions, thereby damaging the company's value and causing an abnormal decline in business performance. Hu Jianping and Gan Shengdao (2007) constructed a model of corporate investment expectation. The manufacturing firms in China were selected as sample for research and analysis. The conclusion was drawn that random expenditures increased with the increase of free cash flow. Significantly positive correlation, the company's future performance is affected, and is negatively correlated with free cash flow. Fu Rong (2007) conducted empirical research on the correlation between company performance change and FCF. The results show that it is not a bad thing for the company to have its own cash flow. The problem is that the agency cost, that is, the random expenditure, will hinder the company from reaching the present. Business performance that should be achieved.
Liu Yinguo et al. (2012) carried out empirical tests on the correlation between FCF and the performance of listed firms, taking into account the time value and lagging effect of capital, and concluded that FCF has a significant negative impact on the companies’ performance in the next year. Jiao Jian et al. (2014) analyzed the panel data of companies listed in China, and the results showed that the level of over-investment was significantly negatively correlated with corporate performance.
With the rapid development of economy, companies have embarked on a profit track, and the free cash flow they hold has also increased. At the same time, the introduction of external managers leads to the separation of the two powers, and the increasing agency costs of FCF will eventually hinder the growth of corporate performance. The following assumptions are made:
Hypothesis 1: High current FCF is an indicator of low future performance in technology companies with R&D expenditures.
Hypothesis 2&3
The board acts as a vital part in the company's internal governance structure. Fama et al. (1983) proposed in their research that directors are the link between shareholders and potential investors, and they have the right to supervise and evaluate the company's management. Morck et al. (1988) proposed that the function of the BOD is firmly related with the composition of the BOD. The stronger the independence of the external independent directors, the better the supervision effect, and the more the internal directors understand the business operations, the higher the correct rate of decision-making. The empirical results of Richardson (2005) show that the management of large companies with independent directors is less likely to over-invest.
Li Wei'an and Jiang Tao (2007) found through empirical analysis that excessive investment behavior is common among listed companies in China, and board governance plays an active role in restraining listed companies from over-investing.
Feng Yuanyuan (2014) selected empirical analysis of private listed companies from 2009 to 2011 and found that there are free cash flow in private listed companies. Expanding the size of the BOD can reduce the abuse of FCF by management to corporate performance. The independent directors played a role but the effect was not significant.
According to the previous research that the BOD, as the most important mechanism of corporate governance, acts as a positive part in balancing the interests of stakeholders and reducing the agency costs of enterprises. The size of the BOD and its composition determine the effectiveness of the BOD. The larger the size of the BOD, the stronger the ability of shareholders to obtain
external key resources, which can increase shareholders' attention to the company and reduce the possibility of FCF being abused. The BOD has the independence to effectively manage the company so that they can fully take the interests of shareholders into account. The greater the proportion of independent directors, the stronger the independence of the BOD. Therefore, the following hypothesizes are proposed:
Hypothesis 2: The negative relationship between the current FCF and future performance of technology companies with R&D expenditures will be mitigated by the board size.
Hypothesis 3: The negative relationship between the current FCF and future performance in technology companies with R&D expenditures will be mitigated by the board independence.
21
4. Research Design
4.1. Sample
The sample is U.S listed technology companies. The initial sample includes about 2000 technology companies with research and development expenditures. The fundamental financial statements data are derived from the COMPUSTAT Fundamentals Annual databases of the Wharton Research Data Services (WRDS) system, which is subscribed by the University of Amsterdam. Corporate governance data are from ISS Directors database. The sample period ranges from 2009-2017. This period also excludes the period of financial crisis that happened in 2008 so that the influence of the financial crisis can be eliminated. The final sample includes 1348 US technology companies with R&D expenditures.
4.2. Independent Variables
4.2.1. Free Cash Flows (FCF)
At present, the academic community has not reached an agreement on the calculation formula for FCF. Livante and Hankel believe that FCF equals operating cash flow minus capital expenditure. Bradford Cornell believes that FCF is the net cash flow generated by cash inflows minus all company expenses, including investment in equipment and working capital, FCF = (operating profit + interest income + dividend income) * (1 - income tax rate) + income tax increase - capital expenditure + depreciation - increase in working capital. Kaplan (1990) believes that FCF equals pre-tax profit minus income tax, plus non-recurring expenses such as depreciation and amortization, minus net operating capital increase and capital expenditure, so FCF is the total amount of post-tax cash flow created by the company. The formula is: FCF = profit before interest and taxes + depreciation and amortization - income tax - capital expenditure- net increase in working capital. Standard & Poor's used Kaplan's algorithm when calculating FCF. This article uses Kaplan (1990) definition of FCF. Considering that the larger the company, the more FCF generated, this paper divides the FCF by the annual sales, and in this way, the influence of the company's size on FCF can be controlled.
Finally, the formula for calculating FCF in this paper is as follows:
𝐹𝐶𝐹
5=
6785&9:;5& 0<;=5&7>#?5& @>#?A:BCD5
1) Board size(Sbd): Scholars have different views on this factor: First, the size of the BOD is negatively correlated with company performance. This is also typical and is the view of most research scholars. Lipton and Lorsch regarded that the BOD with larger size may lead to an inefficient BOD. They propose that the number of board members should be restricted, even if the board's monitoring ability will increase as the board size increases, but the resulting costs will also exceed the above benefits. Lipton and Lorsh pointed out that the optimal board size should be between 7-9; Yermack's empirical results also prove that the size of BOD is negatively correlated with company value. Second, the size of BOD is positively correlated with the corporate performance. Zhara and Pearce's research shows that the size of BOD is positively related to company’s performance. They believe that the more board members, the broader education, technology, and industry context that allows for diverse and high-quality advice on company decisions. Third, the two are not relevant. According to Simpson's research, smaller boards are more likely to be controlled and influenced by managers. When the size of the board becomes larger, their decision-making ability and efficiency are worse. Therefore, they believe that there is no correlation between the size of BOD and business performance.
Board Size(Sbd) is measured as the total number of directors on the BOD. 2) The Percentage of Independent Directors(Ind)
Studies believe that the independence of directors is positively related with the performance of enterprises. Independent directors are mostly constituted by professional well-known scholars and experts or decision makers in other organizations. They are characterized by master of ample specific professional or technique knowledge, and meanwhile the conflicts among the companies and the independent directors are few, due to they have less personal interests in the company. Independent directors are therefore more impartial and objective in making decisions than internal directors. Sarin's research shows that companies that companies increased the proportion of independent directors in the BOD would have a return on earnings higher than the average stock price.
A large part of the positive correlation is also due to the independent directors and the company performance board fulfilling these responsibilities: first, independent directors are able to offer multi-angle, multi-disciplinary suggestion to giving assistance to management in planning and implementing the company's growth strategy; Second, independent directors as the bridges within the companies have the function of
connecting the outside world to the inside of companies, and their reputation benefits the companies to access necessary growth resources more easily.
The Percentage of Independent Directors(Ind) is calculated as the number of outside directors divided by the total number of directors.
4.3. Dependent Variable
4.3.1. Firm Performance 1. Company performance - ROE
This paper chooses the net profit rate of equity (ROE) as an indicator to measure the operating performance of listed companies. There are three main reasons: First, the listed company's annual report uses ROE as the main indicator of information disclosure, so the data is easy to obtain and the calculation is consistent; Secondly, ROE has been widely used in relevant researches and has been widely recognized by foreign academic circles. Third, many securities investment analysis institutions also regard this index as an important analysis and evaluation index of company performance. ROE can reflect how efficiency the total equity is used and reflect the comprehensive management level of the enterprise. The formula for calculating the net profit margin of total equity selected in this paper is the ratio of annual net income to the average balance of total equity at the end of that year.
𝑅𝑂𝐸5 = 𝑁𝐼5 𝐸𝑞𝑢𝑖𝑡𝑦5
4.4. Control Variables
In consistent with the former literature, there are 4 control variables in total were selected. 4.4.1. Control variable 1:
CEO⁄Chairman Separation(CEO-COB), an indicator that would be marked as zero if the chairman of the BOD and CEO are in charge of by one person, and be marked as one if the chairman of the BOD and the CEO are in charge of by various people.
4.4.2. Control variable 2:
Firm size, Demsetz stated that firm with larger size may create higher sales and produce more value, since more resources are available in the companies to be operated and produced into outputs.
𝑆𝑖𝑧𝑒5 = ln (𝑆𝑎𝑙𝑒𝑠5)
4.4.3. Control variable 3:
Leverage ratio, where represented by the debt-to-asset ratio (DA) and calculated as the percentage of total debt divided by the total assets. The debt-to-asset ratio reflects how many of the total assets are financed by borrowing, and it can also measure the extent to which the company is able to protect the interests of creditors during liquidation. The indicator also reflects the proportion of capital provided by creditors to total capital.
𝐷𝐴5 =
𝐷𝑒𝑏𝑡5 𝐴𝑠𝑠𝑒𝑡5
4.4.4. Control variable 4:
The sales growth rate is measured by the ratio of the sales revenue growth of the company during the current year to the total sales revenue of the previous year. This year's sales growth is the balance of the annual sales of this year revenue minus the annuals sales of last year. It is an useful indicator of forecasting the future sustainable expansion capabilities of a company and also an helpful indicator of evaluating the current performance compared to the previous.
Growth5= 𝑆𝑎𝑙𝑒𝑠5 𝑆𝑎𝑙𝑒𝑠5&'− 1
4.5. Hypothesis models:
There are multiple models used to test performance in the literature.
Hypothesis 1: High current FCF is an indicator of low future performance in technology companies with R&D expenditures.
When test the relationship between FCF and the future performance of companies I apply an extension model of George Yungchih Wang. (2010) in which adjust firms performance by considering their debt ratio, growth and firm size. Jaya Abraha and Haitham Nobanee and (2017) test the the relationship among FCF, agency costs, and how they impact the profitability of insurance compaines, in their model, ROE was used as a proxy for performance. The regression model is constructed as follow:
In the above formula, for any company i and in the 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 divided by the mean of total assets. CEO⁄Chairman Separation is additionally controlled, 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 situation, the coefficients (𝛽')
shall be statistically significant. Once the coefficient is negative, it means that more FCF predicts lower company’s performance in the future.
Hypothesis 2: The negative relationship between the current FCF and future performance of technology companies with R&D expenditures will be mitigated by the board size.
The model for the influence of board size on the correlation between FCF and enterprise performance is constructed on formula (1) and the model of former literature (Klein, 1998; Pfeffer, 1972; Coles and ctg, 2008) by adding interaction term between FCF and board size. The regression model is constructed as follow:
𝑅𝑂𝐸5 = 𝛽_+ 𝛽'𝐹𝐶𝐹5&'+ 𝛽`𝑆𝑏𝑑5+ 𝛽b𝐹𝐶𝐹5&'𝑆𝑏𝑑5+ 𝛽c𝐶𝐸𝑂 − 𝐶𝐵𝑂5+ 𝛽d𝑆𝑖𝑧𝑒5+
𝛽k𝐷𝐴5+ 𝛽l𝐺𝑟𝑜𝑤𝑡ℎ5+𝜀5 (2)
Where sbd is board size at year t, FCF*Sbd is the interaction of free cash flow and board size at year t. Interaction term is added to the previous formula and that can influence the interpretation of all the coefficients. In the formula without the interaction term, 𝛽'would be interpreted as the
unique effect of FCF on return of equity. In the formula with the interaction term, 𝛽' explains the effect of FCF on firm performance is changeable by considering the values of board size. According to former literature, the BOD with bigger size can provide better support to the management in the firm and give more effective advices (Klein, 1998). If the hypothesis is supported, the coefficient of interaction term should have a different sign with the coefficient FCF, which means the impact of FCF on the firm performance can be mitigated with the increase of board size.
Hypothesis 3: The negative relationship between the current FCF and future performance in technology companies with R&D expenditures will be mitigated by the board independence. The model for impact of board independence on the relationship between FCF and corporate performance is based on formula (1) and the model of Elloumi and Gueyié (2001) by adding interaction term between FCF and board independence. The regression model is constructed as follow:
𝛽k𝐷𝐴5+ 𝛽l𝐺𝑟𝑜𝑤𝑡ℎ5+𝜀5 (3)
Where Ind is board independence at year t, FCF*Ind is the interaction of free cash flow and board Independence at year t. Similar to the equation (2), the interaction can help explain that the effect of FCF on corporate performance is different for different values of board size. According to former literature, there is a positive relationship between the ownership of the board and the enterprises’ performance. Mehran (1995). If the hypothesis is supported, the coefficient of interaction between FCF and board independence should have a different sign with the coefficient of FCF, which means the impact of FCF on the firm performance can be mitigated with the increase of board independence.
5. Empirical Findings
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 Descriptive Statistics
Table 5-1 illustrates the descriptive statistics for all the variables (The dependent variable: ROE: independent variables: Sbd, Ind and the control variables: CEO-CBO, Size, DA, Growth) of US listed technology companies with R&D expenditures, respectively, listing the standard deviation, maximum, minimum, median, and average of each variable. In order to have a clearer understanding of the sample, for each variable, statistics are described into three levels of percentile: 100%, 25% and 75%. It can be learned from the table that the average ROE of the total sample is 0.076, while the average of the highest 25% ROE for the US listed technology companies in the sample is 1.132 and the average of the highest 75% ROE is 0.124. The average free cash flow for the sample is 0.006, while the average of the highest 25% free cash flow for the US listed technology companies in the sample is 1.242 and the average of the highest 75% FCF is 0.134. The minimum number of the directors on the BOD for the sample is 5 and the maximum number for the sample is 15, the median number of the directors on the BOD is 7, among the highest 25% number of directors, the median number is 12, while among the highest 75% number of directors, the median number is 8. For the Ind, the minimum percentage is 0.2, and the maximum percentage is 0.36, the median percentage is 0.3, among the highest 25% Ind, the median percentage is 0.5, while among the highest 75% percentage of Ind, the median percentage is 0.4. The indicator of CEO/Chairman Separation is among 0-1, because the separation situation doesn’t exist in all the US listed technology companies of the sample. The average size is 21.21 for the sample, while the average of the highest 25% size of the companies in the sample is 23.58, and the average of the highest 75% size of the companies in the sample is 22.02. The average debt-to-asset ratio for this sample is 0.442, while the average of the highest 25% debt-to-asset ratio in this sample is 0.742, and the average of the highest 75% debt-to-asset ratio in this sample is 0.602. The average growth rate of this sample is 1.245, while the average of the highest 25% growth in this sample is 10.16, and the average of the highest 75% growth rate in this sample is 1.396.
Table 5-1. 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 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 1.245 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 clearer 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. 5.2 Pearson correlation analysis
For the sake of avoiding the influence of multi-collinearity, this study tests the correlation between variables by Pearson correlation coefficient. Table 5-2 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 a 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 exits 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 people can learn 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. However, as we can learn from the table that the correlation among the explanatory variables of the sample is not large, so there will be no serious multi-collinearity problem.
Table 5-2. Person correlation matrix.
ROE FCF Sbd Ind
CEO-CBO Size DA Growth
ROE 1 FCF -0.065* 1 Sbd 0.051 0.032 1 Ind -0.026 0.009 -0.515** 1 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 2009-2017. 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. 5.3 Regression Analysis:
Table 5-3 illustrates the regression results of the three hypothesizes, as it shows, the F statistics for all three hypothesizes are significant, which means for each hypothesis, the independent variables as a group, can well 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 FCF on the performance of technology companies with R&D expenditures. The coefficient of FCF is -0.040, and the t statistic is -1.597, which means the coefficient of FCF is statistically significant at the 5% level of significance. As I supposed before, FCF has a negative impact on corporate 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 corporate performance, because they have positive coefficient and statistically significant at the 1% level of significance.
For the Hypothesis 2:
It tests the size of board’s impact on the relationship of FCF and the performance of technology companies. 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 size of BOD is statistically significant at 5% level of significance. That is to say the negative relationship between the current FCF and future performance in technology companies 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 corporate performance, because they have positive coefficient and statistically significant at the 1% level of significance.
For the Hypothesis 3:
It tests impact of board independence on the relationship of FCF and performance of firm with R&D expenditure. The coefficient of interaction term between the board independent and FCF 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.
In conclusion, what we can learn from the regression results is that hypothesis 1 and hypothesis 2 are supported, however, hypothesis 3 isn’t supported.
Table 5-3. 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***
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.
∗ ∗ ∗ indicate significance at the 1% level. ∗ ∗ indicate significance at the 5% level. ∗ indicate significance at the 10% level.
6 Conclusions and Suggestions
6.1 Conclusions
In this study, data of 1348 US listed companies with R&D expenditures from 2009-2017 are used to empirically test the impact of FCF on the performance of technology companies with R&D expenditures and if corporate governance can influence the relationship between firm performance and FCF.
As Meckling (1976) and Fama(1983) proposed: “the holding of free cash flow might lead to self-interest behavior of the management level, and as a result, the FCF might has a negative impact on the performance of enterprises.” Our result supports this argument, and proves that the negative impact of FCF also exists in US listed technology firms R&D expenditures.
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, and test their impact on the negative relationship of FCF and performance of technology companies with R&D expenditures. The result shows that a larger size of BOD can alleviate the negative impact of FCF on performance of technology companies with R&D expenditures, that probably because a board with bigger size will have much more access to useful information. And therefore, a board with big size can improve the corporate performance. (Dalton, 1999). Nevertheless, the impact of board independence is not statistically significant.
There several contributions need to mention. First, this paper is the first empirical research of the impact of FCF 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 research use drag variable to test the current FCF on the future performance of technology companies 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.
The study also has the following implications. First, the results of regression show that expect the FCF has negative impact on the future performance of technology companies with R&D expenditures, and the broad size can mitigate the relationship, the control variables such as the size of companies and the growth rate of companies can also improve firm performance. Further
study can combine these two factors with FCF to test their impact on the correlation between FCF and firm performance.
This paper has several limitations:
First, there are limitations in the choices of indicators. In measuring the company's performance, ROE indicator was selected. The other indicators that can measure the company's performance include ROA, EVA, and price-to-book ratio. Different indicators may bring different results. The selection of control variable indicators in this paper may not be comprehensive.
Second, there exist limitations in data and research methods. The original data in this paper is derived from WRDS. In the process of data processing, discontinuous samples have been eliminated, but it cannot be ruled out that the disclosed information may be biased due to various factors. This paper has a large amount of work in data collection, and there may be some inconsistencies in the process of data collection and processing.
Third, FCF is a relatively new financial concept, and its logical relationship with the company's performance is unique. Due to the limited research ability, my understanding of the FCF theory and the connotation of corporate governance may not be comprehensive and in-depth. In addition, due to the knowledge of econometrics is limited, the model constructed may not be optimal. The above deficiencies will make certain deviations in the research results of this paper. Finally, any research of this type is subject to limitations on the generalizability of its results, and this study is not an exception.
6.2 Suggestions
To reduce the negative impact of FCF on corporate performance, the following suggestions are proposed:
First, improve the internal governance mechanism of the company. Expand the size of the board of directors and integrate experts with a variety of experience backgrounds and skills, but also reduce unnecessary institutional staff and improve the efficiency of production. Enhance the supervision over controlling shareholders, directors and management, and reduce the possibility of encroaching on corporate resources.
Second, implement equity incentives for management. Implementing equity incentives for management is one of the important ways to reduce the cost of agency between owners and managers. Therefore, the shareholding ratio of the management in companies should be
