Definition: Free to Cash flow also known as FCF is the cash flow available to the firm or its equity holders net of Capital Expenditures Bodie, Kane and Marcus (2009). Jensen (1986) defines FCF as cash flow remaining after all positive net present value projects are funded at the relevant cost of capital. Free to Cash Flow per Share which is a measure of a firm’s financial flexibility and it is determined by dividing the free cash flow by the total number of shares outstanding.
Importance: The capacity of a Firm to generate Free Cash flow is one of the most key factors to consider when analyzing the firm from a fundamental point of view. Most investors are familiar with basic indicators such as the price-earnings ratio (P/E), book value, price-to-book (P/B). However Investors, who recognize the significance of cash generation, use the Cash Flow Statements of the Company. Cash flow represents the flow of cash earned (income) and spent (expenditure) in a company, and the Free to Cash Flow is regarded as a subset of the Cash Flow. The free to cash flow valuation approach is considered vital because it takes into consideration the firm’s capital expenditures. Companies with free cash flow that is, cash flow net of capital expenditures can increase the growth, expansion and prosperity of their company.
FreeA cash flow is very relevant because itA provides a company the opportunity to carry out various investments that enhance shareholder value. With insufficient cash, it is difficult for a company toA develop new products, make acquisitions, pay dividends and reduce debt. Based on this we can suggest that firms with positive or high free to cash flow, can reduce their debt or leverage levels, while firms with negative or low free to cash flow will most likely have to increase their debt or leverage levels to maintain the company’s business.
This is consistent with the PECKING ORDER THEORY developed by Myers (1984) and Myers and Majluf (1984), which is based on the premise that there is a strict ordering or hierarchy of sources of finance which implies that firms will have a preference for internal sources of funds followed by debt and then, when such sources are exhausted, equity finance will be used. This implies that firms with high free to cash flow, will have low leverage levels and firms with low free to cash flow will have high debt or leverage levels.
Jensen’s FCF hypothesis is that "firms with high levels of Cash flow will waste it on negative NPV projects. According to Jensen this is likely to arise as a result of large amount of free cash flows, i.e. cash flows in excess of the funds needed to finance all positive NPV projects. Such free cash flows should be paid out to shareholders if the firm is to maximize shareholder value".
Jensen (1986) claims that the corporate restructuring move of the past decade, such as leveraged buyouts, leveraged takeovers and leveraged recapitalizations, are ways for corporations to lessen free cash flows. Increased leverage forces the firm to commit future cash flows to debt servicing, thereby reducing the discretionary cash of managers. This lowers the possibility that managers will invest in value-decreasing projects, thus enhancing
value to shareholders. From this, it has been theorized that Leveraged Buyouts solve the problem by not only removing management but also the debt associated with the LBO reduces management’s discretion when it comes to the cash, because when corporate resources are incompetently managed, shareholders’ wealth is destroyed.
Lang and Litzenberger (1989) empirically test the FCF hypothesis their results provide empirical support for the FCF hypothesis. It generally explains the benefits of debts or leverage in reducing agency costs of free cash flow.
The Free to Cash Flow per Share is an important company financial indicator based on the research and study above it reflects the Cash position of the firm and therefore is important to the Researcher in determining the leverage ratio or Capital Structure of the Firm and also to the Manager in its effect on the Firm’s Strategic Decisions, thus It is of high relevance in the Model in determining the level of leverage by the sample firms.
Definition: Market to book ratio, is the ratio of price per share divided by book value per share. It is seen as a useful measure of value and an indicator of how aggressively the market values the firm Bodie, Kane and Marcus (2009).
Importance: Market to book ratio has been used severally by many researchers in analysing the Theories of Capital Structure and as an important indicator of Corporate Financial and Strategic Decisions. Market to Book ratio also called the "price to book ratio" and is used to determine whether the stock of a firm is undervalued or overvalued. It is most especially used as a measure of growth opportunities of the firm. A ratio above 1(one) suggests a potentially undervalued stock, while a ratio below 1(one) suggests a potentially overvalued stock.
It is generally accepted that market to book ratio, which is necessarily seen as a measure of a firm’s growth opportunities, is negatively related to leverage ratio, that is firms with higher market to book ratios have lower leverage based on empirical studies by Hovakimian (2004), Baker and Wurgler (2002). However some other researchers such as Long Chen and Xinlei Zhao (2006) came to the conclusion that the relationship between the market to book ratio and leverage ratio is not monotonic and can be positive or negative for various firms.
The Trade off Theory- The trade-off theory is based on the premise that firms choose optimal leverage ratios by balancing borrowing costs against benefits. According to this theory, firms with higher market to book ratios also have higher growth opportunities and they intend to keep lower current target leverage ratios thus they are more likely to issue equity when they realize new investment opportunities and downwardly adjust their target leverage ratios.
Long Chen and Xinlei Zhao (2006) carried out a study on the relationship between the market to book ratio and debt financing costs using corporate bond data. They made use of credit spread which is the difference between corporate bond yield and treasury bond yield of similar maturity. The credit spread data and related bond information covering the 1995- 2002 period. The purpose was to examine the relationship between credit spread and market to book ratio after controlling for other determinants.
The estimation technique uses was the pooled panel regression which where were controlled for heteroskedasticity and autocorrelation. With three control variables (i) bond-specific, including bond rating and maturity; (ii) firm-specific, including size, leverage ratio, equity volatility, and equity return; and (iii) macro variables, including 3-month T-bill rate and interest rate slope (the difference between 10-year and 1-year interest rate), their conclusion was that credit spread is significantly negatively related to the market-to-book ratio.
Therefore, firms with higher market to book ratios face significantly low borrowing costs, which mean the firms can borrow more, since debt is cheaper for them. These results suggest that the relationship between the market to book ratio and leverage ratio might not be monotonic (can either be positive or negative) as earlier discussed.
According to Long Chen and Xinlei Zhao (2006) since the trade off theory "predicts that firms choose optimal leverage ratios by balancing borrowing costs against benefits. A version of the trade off theory that is consistent with the empirical evidence in their research is as follows: Higher market to book ratios is related to lower borrowing costs. For firms with low to medium market to book ratios, the benefits from borrowing exceeds external equity issuance, and firms make optimal decisions by borrowing more. Alternatively, firms with high market to book ratios have high growth opportunities since they are faced with low borrowing costs and thus preserving low leverage target ratios becomes a major concern". They suggested that fresh insights are needed to explain the relationship between the market to book ratio, growth opportunity, and leverage ratio.
The market to book ratio was also used as an indicator of growth opportunities, in a research paper by Basil Al-Najjar and Peter Taylor, based on their study of Jordanian firms they found a strong significant positive relationship between the potential growth rate, as indicated by the market to book ratio, and leverage, this explains that with high growth opportunities the firms have a preference for debt financing as a means of financing their investment opportunities. This is also evidence that the relationship between leverage and Market to book ratio is not monotonic.
Based on this study of The Market to Book Ratio is very relevant in this research work and in the Model because it is an essential financial indicator for the Researcher in determining the Capital Structure or Leverage Ratio of a Firm, and for the Manager in investigating how it affects the Firm’s Financial Strategic Decisions.
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