Vogt (1997) has explained Free cash flow as operating income before depreciation, less interest expense on debt, less income taxes, less preferred and common dividends. FCF is a coverage ratio representing the amount to which current time generated free cash flow is sufficient to cover next time's capital expenditures. (Vogt, 1997)
Vogt (1997) explains FCF is the sum of cash that a business has left over after it has compensated all of its expenses. Negative free cash flow is not inevitably a sign of a bad company, however, since many new companies put a lot of their FCF into capital spending, which diminishes their free cash flow. Although if a company is spending so much FCF, it should have a good grounds for investing and it should be making high rate of return on its capital spending. While FCF doesn't receive as much interest as profits do, it is considered by many experts to be a better sign of a company's financial health. (Vogt, 1997)
Poulsen (1989) FCF is a cash flow in hand for giving out among all the share holders of an organization. Those include holders of equity, debt, preferred stock, convertible security, and so on. (Poulsen, 1989)
Vogt (1997) explains FCF hypothesis as, it forecasts that the market will react adversely to capital spending. The FCF hypothesis also explains that undistributed FCF is positively related to capital expenditure, but the significance of free cash flow to capital expenditure will be positively related to business size and for insider ownership it will be negatively related. (Vogt, 1997)
Jensen (1986) suggests Free cash flow is a cash flow in surplus of that necessary to fund all projects that have positive NPV when discounted at the suitable cost of capital. When FCF is present and shareholder monitoring is imperfect, the classic shareholder manager problem arises. Administrations have a propensity to overinvest in order to capture the financial and non-financial gains of increased business size. (Jensen, 1986)
Jensen (1986) suggests free-cash-flow hypothesis as excess FCF is wasted on value destroying capital expenditure because managers have a personal reason to raise the asset size of the firm rather than give out cash to shareholders. (Jensen, 1986)
1.1 Statement of Problem
The problem studied here is
"To Study the Impact of Free Cash Flow on Capital Spending"
1.2 Objective
The objective of this paper is to find is there any relationship between free cash flow and capital spending.
1.3 Hypothesis
H1: Free Cash flow has a positive relationship with capital spending.
1.4 Justification for Automobile sector
Automobile sector has seen massive growth in the last ten years. It requires very huge amount for capital spending. In this sector many there are many companies which are global and listed in many exchanges around the globe.
CHAPTER TWO
2 Review of the Related Literature
The aim of this study is to observe whether free cash flow is important in the firm's capital spending decision or not.
The internally generated cash flow on financing capital spending is well recognized. Modigliani and Miller's (1958) insignificance suggestion asserts firms to carry out all positive NPV investments despite of the financing source. (Modigliani & Miller, 1958)
Jensen (1986) explains FCF as a cash in surplus of that necessary to fund all above zero NPV projects. Free cash flow entices managers to expand the scale of procedures and the size of a business, thus increasing administrators' command and personal compensation, by spending free resources in projects that have non-positive NPV's. These unprofitable expenditures are an aspect of the basic disagreement of interest between owners and managers. FCF is not consistent with the goal of owner capital maximization. Expansions washed out by management instead could have been circulated to the owners of stock holders as dividends or invest in stock or mutual organizations in the shape of lower payments, higher dividends, or higher investment profits. The existence of free cash flow provides managers with an opportunity to waste cash on unprofitable capital spending. These unprofitable capital spending represents an incremental cost of the owner-manager conflict. (Jensen, 1986)
Jensen (1986) suggests that the majority of accessible evidence on the FCF hypothesis highlights on changes in financial structure. Jensen suggests that leveraged takeover activities are one way of controlling FCF because the debt incurred in such matters forces managers to pour out extra cash. It looks at the cross sectional relation between FCF and capital structure and finds some facts that managerial forms specific to the industry of oil have different agency costs of FCF. Specifically, the Capital expenditure of FCF is lower in trusts and limited partnerships than in organizations. (Jensen, 1986)
Jensen (1986) studies test for differences in FCF and Capital expenditure in automobile insurance industries. The point is to inspect whether businesses shape changes managerial behavior with respect to the holding of FCF rather circulating or spending. (Jensen, 1986)
Jensen's (1986) theory predicts that Capital expenditure of assets is driven by FCF. Previous research suggests that the agency problems between owners and administrations are greater in mutual firms than in stock firms, which leads to the belief that the FCF problem will be lower in stock insurers than in mutual insurers. (Jensen, 1986)
James A. Gentry (1990) analyzed capital spending with total cash outflow and found out that the percentage of cash outflows going to capital investment (NI/TCF) ranged from an outflow of 60 per cent or more. The giant companies invested a higher percentage of their total outflow in plant and equipment than companies in the other size categories. The small companies invested the lowest percentage of their total outflows in capital. (James A. Gentry, 1990)
Research was applied to agricultural firms by Farrell E. Jensen, (1993) which showed that results are consistent with previous studies for nonagricultural firms which show that internal cash flow variables are important in explaining investment. Result indicate that internal cash flow variables are important and that the addition of internal cash flow variables can improve the explanatory power of agricultural investment models. In terms of elasticity, investment was more responsive to internal cash flow variables. (Farrell E. Jensen, 1993)
Vogt's (1994) explains the relationship of cash flow and capital spending by analyzing the free cash flow theory of Jensen's (1986) and find outs that, since monitoring is costly, and managers can benefit from over spending, FCF will significantly influence capital expemditure after controlling for the cost of capital. Capital expenditure of firms not distributing dividend will be more influenced by FCF than investment spending of the firms who have dividends distibution. This follows because firms who don't pay dividend are able to retain all FCF and still they don't reach the retention limit. (Vogt S. , 1994)
Worthington (1995) has found that cash flow measures enter industry level investment equations positively and significantly, even after investment opportunities are proxied by capacity utilization variables. The effect of cash flow is greater in durable goods industries than in nondurable goods industries. (Worthington, 1995)
Klaus Gugler, Dennis C. Mueller, and B. Burcin Yurtoglu in 2004 tested the following hypothesis first asymmetric information (AI) hypothesis which forecasted that firms underinvest and have returns on spending higher than their costs of capital, and second the managerial discretion hypothesis which forecasts overspending and returns on spending less than the costs of capital, using the ratio of returns on spendings to costs of capital for each organinzation is a natural way to make this recognition. (Klaus Gugler, 2004)
Nathalie Moyen in 2004 explained the fact that the cash flow sensitivity of firms described by the constrained model is lower than the cash flow sensitivity of firms described by the unconstrained model can be easily explained. In both models, cash flow is highly correlated with investment opportunities. With more favorable opportunities, both constrained and unconstrained firms invest more. (Moyen, 2004)
Raj Aggarwal in 2005 started a study on four controlling for the investment opportunity set, and he concluded investment levels are significantly positively influenced by levels of internal cash flows. The strength of this association generally increases with the level of financial constraints faced by firms. Overall, these findings seem strong to the nature of the financial system and indicate that most firms operate in financially incomplete and imperfect markets and find external finance to be less attractive than internal finance. (Raj Aggarwal, 2005)
Bo Becker, and Jagadeesh Sivadasan in 2006 concluded for their research paper that in frictionless financial markets, investment does not depend on internal cash flows. In a large European data set, results indicate that firms invest more on average when they have higher cash flow. Contribution to the literature is being made by testing formally if the coefficient on internal resources (cash flow) is related to a country's financial development. Comparing countries, it is further discovered the cash flow effect is indeed stronger in countries with weaker financial development. This suggests that financial constraints are strongest when financial development is low. ( (Bo Becker, 2006)
Vogt S. (1994) explains the case of capital spending, the observed results tend to support the FCF description of the free cash flow and capital spending relationship. Actions that supports the FCF assumption, however, it is found in small organizations that dividends are paid less. In the case of R&D spending, outcomes are more valid with the FCF assumption. These outcomes jointly hint that the cause that free cash flow financed spending has on firm worth depends on dividend performance, size of asset, and the nature of capital expenditure. (Vogt S. , 1994)
Vogt S (1994) explains FCF assumption suggests that cash flow should influence capital expenditure. The firms not disburseing dividends should demonstrate the strongest relationship between free cash flow and capital spending, while those disburseing high dividends should show the weakest relationship. (Vogt S. , 1994)
Vogt S. (1994) gives an explaination on Free cash flow, however it is still a important variable in the capital expenditure behavior of small, low-payout organizations. The restraint predicts, less than those connected with the larger organizations in the low payout group it is still highly important. Therefore, the asymmetric information persuaded FCF assumption explanation cannot be excluded. The most reasonable point is that both FCF and asymmetric information are significant factors contributing to the influence of FCF on capital expenditure. (Vogt S. , 1994)
Vogt S. (1994) explains different inducements that R & D and capital expenditure may generate for administration over time R&D represents a spending on insubstantial assets whose impact on the size of asset and the prospect of future cash flows of the organization is extremely unsure and no likely to be realized in the coming future. Fixed assets spending is likely to generate more certain cash flows in the coming future as well as enhance the tangible assets of the organization. The effect of fixed asset spending is to generate FCF that can be used in the next year. Therefore, capital expenditure may be more vulnerable to FCF problems than R & D spending. (Vogt S. , 1994)
Vogt S. (1994) suggests that FCF financed capital expenditure is marginally inefficient and provides primary facts in support of the FCF hypothesis. The negative and concentrated relationship found in the aggregate data in organizations paying less dividends over the sample period, in large organizations, and most strongly in large organizations paying less dividends. (Vogt S. , 1994)
Vogt S. (1994) explains significant implications for financiers and directors. While the research suggests that FCF financed capital expenditure is slightly unproductive for some organizations, the possible sources of this inefficiency have also been known. FCF financed growth by large, low-dividend organizations tends to be value destroying, while FCF financed growth is value creating for small, less dividend organizations. The importance of dividends as a technique of justifying agency costs of FCF, moreover it is confirmed. Managers of FCF rich firms may think increasing dividend payouts as a technique of increasing the effectiveness of their capital expenditure decisions. A continued high dividend payout policy might also signal to investors that further and costly monitoring of capital expenditure decisions is unnecessary. (Vogt S. , 1994)
Mizen (2005) explains the relationship between cash low and investment in all but a few papers are based on sample-splitting between constrained and unconstrained firms taken from a single country. This paper seeks to explain why the the degree of sensitivity appears to be greater. It extends the literature by examining from a number of perspectives the behaviour of firms. The research article proposes a number of hypotheses that are explored in turn. A first possible reason is that firms in market-oriented financial systems show greater sensitivity to cash flow because borrowers and lenders operate at arms length compared to those in relationship-oriented systems. A second possible cause for differences in response to cash flow across countries is that the samples of firms taken from each country might differ in composition with respect to particular characteristics, for instance size. Equally, the industrial type may be an important determinant of investment sensitivity to cash flow since industries differ considerably in terms of the size of firms, capital-intensity, borrowing capacity, openness and the durability of their output. (Mizen, 2005)
Vogt S. (1997) explains the strong control that FCF has on capital expenditure is well documented. On the FCF hypothesis of Jensen (1986) as explanations for the importance of FCF on capital expenditure. Initial outcomes represent relations related to those uncovered in previous studies. Capital expenditure has a positive and statistically significant relation with FCF. Organizations with constructive investment opportunities are accountable for much of the positive, excess profits. Also, for organizations announcing expenditure increases, the level of announced capital expenditure is strongly and positively associated to the level of FCF. The influence of this relation increases for organizations with profitable capital expenditure opportunities, as organization size declines, and as the ratio of insider ownership increases. Further study suggests that significant variety exists in the capital market's response to FCF financed capital expenditure. (Vogt, 1997)
Vogt (1997) indicates a positive and significant investment were found in the sample announcing FCF Capital expenditure in firms with low FCF relative to capital expenditure, and to a lesser extent, in organizations with high levels of insider ownership. Experiments elaborating the variation in returns disclose that excess profits for medium and small organizations in the sample are positively related with unpredicted increases in planned expenditure. These experiments also advise that the reactions by the market are more favorably towards announced capital expenditure by small organizations when the planned expenditure is more dependent on FCF. On the other hand, excess profits for the largest organizations in the sample are negative, however statistically significant. Cross-sectional regressions identify that large organizations have, excess profits and are negatively associated to the degree that undistributed FCF is available to finance planned capital expenditure, and positively associated to their capital expenditure opportunities. These outcomes are reliable with the hypothesis that small organizations follow a FCF model like that explained in the previous studies. Because small organizations and high ownership organizations are the most likely to encounter the liquidity limits associated with asymmetric information, these organizations are also the most probable to forgo profitable capital expenditure in times of FCF shortages. As FCF rises, the set of profitable capital expenditure foresee the organization can undertake also increases. Therefore, capital expenditure is met with positive investor reactions, particularly when expenditure is dependent on FCF. (Vogt, 1997)
Vogt (1997) finds some sign that is dependable with the FCF hypothesis. Excess profits are negatively associated to large organization's ability to cover capital expenditure with FCF. This is reliable with the FCF hypotheses. This apparent variety in the market's reply to capital expenditure decisions suggests different capital expenditure financing policies for organizations that seek to improve investor value. Small organizations with sizeable insider ownership and organizations that are generally FCF constrained emerge to be enhanced, by financing capital expenditure with FCF. These organizations might think policies of conserving undistributed FCF through less payout and controlled policies, thus encouraging new capital expenditure from internally created funds. No proof that FCF financed capital expenditure improves these organizations' market values. Therefore, limited sign exists that such a financing strategy could decrease market worth for large, little insider owned, and FCF rich organizations. (Vogt, 1997)
Alti (2003) research paper analyzes the sensitivity of investment to cash flow in the benchmark case where financing is frictionless. Overall, the results indicate that the frictionless benchmark is able to account for the observed magnitudes of the investment-cash flow sensitivity, and the patterns it exhibits. Investment is sensitive to cash flow, even after controlling for its link to profitability by conditioning market. Furthermore, the sensitivity is substantially higher for young, small firms with high growth rates and low dividend payout ratios, as it is in the data. The uncertainty these firms face about their growth prospects amplifies the investment-cash flow sensitivity in two ways. First, the uncertainty is resolved in time as cash flow realizations provide new information about investment opportunities. This makes capital spending highly sensitive to free cash flow surprises. (Alti, 2003)
James A. Gentry (1990) tells about Free cash flow analysis shows that the financial health of a company depends upon its ability to generate net operating cash flows that are sufficient to cover a hierarchy of cash outflows. The profiles generated from a large sample of companies show that relative cash flow components vary across company size and across industry groups. The researcher hopes that these profiles will serve as benchmarks for comparing cash flow components and encourage financial analysts to use cash flow analysis. (James A. Gentry, 1990)
Bo Becker (2006) research explains that in frictionless financial markets, investment does not depend on internal cash flows. In a large European data set, the researcher finds that firms invest more on average when they have higher cash flow. The researcher contributes to the literature by testing formally if the coefficient on internal resources (cash flow) is related to a country's financial development. Comparing countries, the researcher finds that the cash flow effect is indeed stronger in countries with weaker financial development. This suggests that financial constraints are strongest when financial development is low. The effect is weaker inside conglomerates and is probably not driven by the East-West difference. This is consistent with the idea that conglomerates ease internal financial constraints. Industries with few low liquid assets may experience bigger benefits of financial development (i.e. the cash flow coefficient is reduced more by financial development in low liquidity industries). However, the proof for this is diverse. Our findings suggest that financial frictions operate in Europe. They suggest that financial development is beneficial because it reduces financial constraints at the firm level and therefore relaxes the correlation between internal resources and investment. (Bo Becker, 2006)
CHAPTER THREE
3 Research Methodology
The research aims to find the association between Free Cash Flow and Capital Spending; evidence from Automobile sector of Pakistan. The linear regression analysis used to find out whether Net Capital Spending is depended on Free Cash Flow or not.
3.1 Sources of Information
The research work is done on Automobile sector of Pakistan. All the required data is extracted from financial reports of the companies which are available on their website and hardcopies of financial reports are also available. All the values of variables are on annual basis.
3.2 Equation
Dependent Variable = Independent Variable
Change in Fixed Assets = Free Cash Flow
3.3 Sample size
Sample size used by the researcher is taken from the year 1999 to 2008 or Musharaf Era.
3.4 Variables
The variables are as follows:
Independent Variable = Free Cash Flow (FCF)
Dependent Variable = Net Capital Spending
3.4.1 Independent Variable
Free Cash Flow
Free cash flow, is explained as operating income before depreciation, less interest expense on debt, less income taxes, less preferred and common dividends. FCF is a coverage ratio representing the amount to which current period generated FCF is sufficient to cover next period's capital expenditures. (Vogt, 1997)
Free cash flow is determined by integrating the cash receipt and disbursement items from the income statement with the change in each balance sheet item; the sum of the cash inflows equals the sum of the cash outflows.
FCF = Operating Income + Depreciation - Interest Expense - Income Taxes - Dividends
3.4.2 Dependent Variable
Net Capital Spending
Capital spending is an amount a company spent buying or upgrading assets, such as machinery, equipment, property, fixtures during the year and purchasing subsidiaries.
Capital spending is a payment by a firm for basic assets like property, fixtures, or machinery, but not for every day operations such as payroll, inventory, maintenance and advertising. Expenditure is supposedly increase the value of firm's assets and is usually planned to improve productivity.
Net Capital Spending = (Current Year - Previous Year)
3.5 Statistical Test
The technique used by the researcher is Multiple Regression. Multiple linear regression analysis is a statistical instrument that can be used to analyze the association between a dependent variable and several independent variables. The objective is to use the independent variables whose values are identified to forecast the single dependent variable value selected by the researcher. (Hair, 2006)
Multiple Linear Regression estimates the beta of the linear equation, involving more than one independent variables that best calculate the value of the dependent variable. Like; you can try to calculate a salesperson's total yearly sales from independent variables such as age, education, and years of experience.
SPSS is used by the researcher to run regression analysis on the variables. Total variation explained by the regression model as indicated by R square is 0.262 or 26.2 %. So the variation explained by the independent variable FCF is positive but it is very low. (Hair, 2006)
The change in the R Square statistic that is produced by adding or deleting an independent variable. If the R Square change associated with a variable is large, that means that the variable is a good predictor of the dependent variable. (Hair, 2006)
The F test for the regression model is significant which indicates that regression model is best fit. (Hair, 2006)
Regression model result is pointing out that FCF has a positive impact on Net Capital Spending. (Hair, 2006)
4 Implications
The intention to inspect whether organizational form affects managerial performance with respect to the holding of FCF rather dispensing or investing.
Important implications for both investors and managers are found in researches. While the study shows that FCF financed capital expenditure is marginally unproductive for some organizations, the possible sources of this inefficiency have also been recognized. FCF financed growth by large, low-dividend organizationss tends to be value destroying, while FCF financed development is worth creating for small, low paying dividend organizations. The significance of dividends as a technique of mitigating agency costs of FCF. Managers of FCF rich companies may think increasing dividend payouts as a technique of increasing the effectiveness of their capital expenditure decisions. A continuous high dividend payout strategy may also signal investors that extra and costly monitoring of capital expenditure decisions is unnecessary.
This study will help mangers to make a good dividend payout policy and it will be useful for capital expenditure decisions also.
CHAPTER FIVE
5 CONCLUSION
For the Automobile industry of Pakistan the period 1999 to 2008 a unique research has been done to study the cause of the well documented association between free cash flow and Capital expenditure. The FCF hypothesis, which supposes managers overinvest FCF in negative or zero NPV investment projects. Outcomes from several experiential specifications point out that the influence of free cash flow on capital expenditure is weaker for firms belonging to Automobile sector of Pakistan. This result suggests that free cash flow doesn't effects capital spending in the automobile sector of Pakistan.
As the previous studies showed this study also verifies that there is a significant association between free cash flow on capital spending.
Free cash Flow is likely to result in managers relaxing the profitability criteria necessary to justify a specific project but such profitability criteria are still useful in ranking projects.
FCF cannot be observed directly. Instead, scarce profitable investment opportunities; considerable, steady cash flow; low financial leverage; and high levels of diversification are identified as indicators of free cash flow. The results indicate that Capital expenditure of equity is partially driven by FCF.
