Investigating the Relationship between Firm s Corporate Governance, Free Cash Flow, and Overinvestment

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1 Investigating the Relationship between Firm s Corporate Governance, Free Cash Flow, and Overinvestment Mahdi Filsaraei Department of Accounting, Bojnourd Branch, Islamic Azad University, Bojnourd, Iran. Morteza Moradi M.A. Student of Accounting, Hakiman Institute of Higher Education, Bojnourd, Iran. Javad Askari zadeh M.A. Student of Accounting, Hakiman Institute of Higher Education, Bojnourd, Iran. Masoumeh Bahadori M.A. Student of Accounting, Hakiman Institute of Higher Education, Bojnourd, Iran. Maryam Mohseni M.A. Student of Accounting, Hakiman Institute of Higher Education, Bojnourd, Iran Abstract This study attempted to investigate the impact of free cash flow on overinvestment as well as the impact of firm s corporate governance on this relation in listed firms in Tehran Stock Exchange. Therefore, the data from 116 firms listed in Tehran Stock Exchange during 2010 to 2014, multivariate regression, and panel data model were used. The results showed that there is a direct and significant relationship between free cash flow and overinvestment in listed firms in Tehran Stock Exchange and the mechanisms of firm s corporate governance cannot modify this relationship. Key words: free cash flow, corporate governance, overinvestment, Tehran Stock Exchange Introduction Investment is one of the most important components of aggregate demand and plays a determining role in economic fluctuations and economic growth of a country and seems very important. Firms have always considered investment as one of the important ways of firms development and avoiding stagnation and backwardness in different issues. Meanwhile, limitations in sources have led to the great importance of increasing investment efficiency as well as investment development. In general, investment efficiency means accepting projects with positive net present value, and investment inefficiency means selecting projects with negative net present value (overinvestment) or deselecting investment opportunities (underinvestment) (Saghafi and Mo tamedi, 2011). In a complete capital market, there will not be a relationship between free cash flow and firm s investment level (Modigliani and Millier, 1958). Meanwhile, prior studies have shown a direct relationship between them (Hubbard, 1998). There are two interpretations for this relationship: (1) information asymmetry; and (2) agency costs. To explain information asymmetry, Myers and Majluf (1984) showed that in a complete capital market, information asymmetry leads to increasing capital cost, and it will be costly in collecting external financing for the firm. Meanwhile, external financing constraints force firms to reduce flexible investments and to invest more from internal free cash flow, due to its lower capital cost (Fazzari et al, 1988; Hoshi et al, 1991; Whited, 1992; Hubbard, 1998). Another interpretation is agency costs. Agency costs result from the separation of ownership from firm s control. This can create a strong incentive for management in firms with free cash flow to invest in projects with negative current value (Jensen, 1986; Stulz, 1990). Interpretations related to agency costs show that management is likely to invest in projects that are profitable in its view, but they are not good for firms owners, especially when monitoring on management is poor. In this regard, in examining the relationship of overinvestment levels and free cash flow, Richardson (2006) came to the conclusion that in firms with high free cash flow, overinvestment level would be restricted, and mechanisms of firm s corporate governance can reduce overinvestment. The following 32

2 questions are raised in this study: (1) Does firm s free cash flow influence overinvestment in firms listed in Tehran Stock Exchange?, and (2) do corporate governance mechanisms affect the relationship between firm s free cash flow and its overinvestment? Background of the study 1. Foreign studies In a study titled Free Cash Flow, Over-Investment and Corporate Governance in China, Chen et al (2015) investigated whether free cash flow and mechanisms of firm s corporate governance affect firm s investment level or not. The results showed that overinvestment has a direct relationship with free cash flow; meanwhile, some mechanisms of firm s corporate governance such as ownership concentration and board independence can have an effective monitoring role. While studying the effect of financial reporting on investment efficiency, Wang et al (2015) investigated the simultaneous effect of financial reporting quality and free cash flow on investment efficiency as well, in a study entitled Financial Reporting Quality, Free Cash Flow, and Investment Efficiency. The results showed an inverse and significant relationship between financial reporting and investment efficiency. On the other hand, free cash flow would enhance the inverse relationship between financial reporting quality and overinvestment. In a study titled Investment Cash Flow Sensitivity under Managerial Optimism: New Evidence from NYSE Panel Data Firms BenMohamed et al (2014) showed that management optimism affects the relationship between investment and internal cash flow. Also, the results of their study showed that a direct significant relationship exists between investment and cash flow within the total sample. In a study entitled Financial Reporting Quality, Debt Maturity and Investment Efficiency Gomariz and Ballesta (2013) concluded that financial reporting quality mitigates the problem of overinvestment. Also, debt maturities can improve investment efficiency through reducing under- and over-investment. They also found that firms that use more (less) short-term debt have lower (higher) financial reporting quality. In a study titled Managerial Sentiment, Investment Opportunity and Firm Performance Ying and Fen (2013) Concluded that the relationship between growth opportunities and firm performance in firms with management s non-optimal use of free cash flow is weaker than the relationship between growth opportunities and firm performance in other firms. In their study entitled Interactions between Free Cash Flow, Debt Policy, and Structure of Governance Fatma et al (2011) concluded that according to Jensen's theory of free cash flow, debt policy can limit the risk of cash flow as the main governance mechanism. Their results also showed that managerial ownership can reduce the level of free cash flow agency costs. Also, ownership concentration increases the risk of free cash flow. Using the data from emerging markets, Chen et al (2011) investigated the effects of financial reporting quality on under- and over-investment and concluded that higher financial reporting quality helps firms with under-investment problems to invest and firms with overinvestment to reduce their investment level. 2. Domestic studies Ganji and eskandari (2014) examined Capital market response to accruals, free cash flow, and net operating assets in Tehran Stock Exchange. Their results indicated that there is not a significant relationship between accruals and firm s value at 95 percent confidence level but there is a significant relationship between free cash flows, net operating assets, and firm s value which increases through an increase in net operating assets. But firm s value decreases by an increase in free cash flow. Khodadadi et al (2013) examined the Impact of Ownership Structure on the Relationship between Free Cash Flow and Optimal Use of Assets. Their results showed that the relationship between free cash flows and optimal use of negative assets becomes more significant by increasing managerial ownership. Managers are willing to invest free cash flows in projects with personal interests, and they do not follow the predicted procedures and even ignore the negative net present value of the project. Some investment activities may have positive returns in general, but these returns are less than the capital cost. 33

3 Rezaei and Teymouri (2012) investigated Interactive Relationship between Free Cash Flow Risk, Corporate Governance Structure, and Corporate Debt Policy. Their results showed that there is not a significant relationship between corporate governance (ownership concentration and institutional ownership) significant and free cash flow risk. Also, there is a significant and positive relationship between financial leverage and tangible fixed assets, firm size, and growth opportunities, a negative significant relationship between leverage and income tax, and a significant negative relationship between board independence and the debt with free cash flow risk. Saghafi et al (2011) examined Accounting Information Quality, Overinvestment, and Free Cash Flow. Their results showed that the higher the accounting information quality is, the less the issue of overinvesting would occur, and this relationship occurs in firms with more high free cash flow, and the effect of overinvestment reduction through accounting information quality is far more in these firms. In their study, Arab Salehi and Ashrafi (2011) examined the relationship between financial constraints and investment sensitivity to cash flow. It is noteworthy that to classify firms in two groups with and without financial constraints, the amount of firms cash reserves was considered as the main classifier variable. The results indicated the positive role of cash reserves in reducing investment sensitivity to cash flow. On the other hand, no particular superiority was observed in using cash reserves optimal model compared to the traditional criteria of financial constraints. Mahmoud Abadi and Mehtari (2011) investigated the relationship between accounting conservatism and investment efficiency of firms in Tehran Stock Exchange. The results showed that there is a significant relationship between accounting conservatism and future investment at the firm level and at the level of seven groups of industry. Also, there is a negative significant relationship between firm size and future investment at the level of all firms and chemical, food, and pharmaceutical industries, a significant positive relationship between the ratio of market value to book value and future investment at the level of all firms and wood and textile, chemical, metal, ceramic, and tile industries, and a negative significant relationship between financial leverage and future investment at the level of all firms and in food and pharmaceutical industries. Resaeiyan et al (2010) examined The Effect of Inter-Organization Monitoring Mechanisms of Corporate Governance on Cash Holdings in Tehran Stock Exchange. Their results indicated that there is a significant negative relationship between the percentage unbound members of the board and cash holdings in Tehran Stock Exchange. But no significant relationship exists between the percentage of institutional investors and cash holdings. Methodology This is an applied study in terms of purpose because its results can be used in managers and investors decisions. In terms of inferring the hypotheses, it is among correlation studies because regression techniques have been used to find the relations between the variables. Also, since conclusions have been drawn through testing the existing data, this study is among positive studies. Hypotheses Given the presented materials, the following hypotheses are developed: 1. There is a significant relationship between free cash flow and overinvestment. 2. Corporate governance and its mechanisms are effective on the relationship between free cash flow and overinvestments The percentage of major ownership affects the relationship between free cash flow and overinvestment The percentage of institutional ownership affects the relationship between free cash flow and overinvestment Board independence affects the relationship between free cash flow and overinvestment. 34

4 Population and sample Applied mathematics in engineering, management and technology 4(2) 2016:32-39 The population of the study includes all listed firms in Tehran Stock Exchange during 2010 to The sample was selected through systematic elimination from the population. The sample consists of all firms in the population that meet the following criteria: 1. Be present in the Exchange during the period of the study. 2. Do not have changes in the financial period during the study. 3. Be not among companies in the field of financial activities, such as investment firms, banks, insurance companies, and financial institutions. Since these institutions are different in the nature of their activities and their main income is from investment and are dependent on other firm s activities, thus, they are different from other firms in nature and therefore, will be removed from the population. 4. The required data for the variables be available during the period of 2010 to Their financial period ends at each year, so that the data can be put together and be used in panel form if required. Considering the above mentioned conditions, 116 firms were selected as the sample of the study. It is worth mentioning that each firm has 5 sets of extractable financial information in financial statements and other related information sources during 2010 to Models and variables Free cash flow It is net cash flow from operating activities minus net investment activities divided by total assets. Overinvestment To calculate overinvestment, the proposed model by Biddle et al (2009) have been used: Investment i,t = β 0 + β 1 SalesGrowth i,t-1 + є i,t Where: Investment it = Total investment of firm i in year t, which, according to Gomariz and Ballesta (2013) is the net increase in tangible fixed assets divided by total assets of the previous year. SalesGrowth i,t-1 = Reflects sales growth, which is the rate of the increase in firm i s sales in year t-1 compared to the year t-2. If the investment of the next year is more than sales growth, the residual of the above model will be positive, and it means that overinvestment has occurred. If the investment of the next year is less than sales growth, the residual of the above model will be negative, and it means that underinvestment has occurred. Thus to calculate overinvestment, if the investment is excessive, its values will be put, and otherwise, it will be zero. Corporate governance In this study, the percentage of major ownership (the percentage of shares owned by owners of more than 5% of the firm shares), the percentage of institutional ownership (percentage of shares owned by institutions such as banks, insurance companies, investment companies, etc.), and board independence (the ratio of unbound members to the entire board members) have been used as the mechanisms of corporate governance. The model of testing the firs hypothesis 35

5 The following model will be used to test the first hypothesis (Chen et al, 2015): I + t = β 0 + β 1 FCF 0 t + β 2 FCF 0 t + ε t Where: Dependent variable: I + t= firm s overinvestment. If overinvestment has been done, its value will be put, otherwise, it will be zero. Independent variables: FCF 0 t = If free cash flow is negative, it will be the ratio of free cash flow to the firm s assets, and otherwise, it will be zero. FCF 0 t = If free cash flow is positive, it will be the ratio of free cash flow to the firm s assets, and otherwise, it will be zero. The model of testing the second hypothesis The following model will be used to test the first hypothesis (Chen et al, 2015): I + t = β 0 + β 1 FCF t + β i Governance Factors t + Where: β i Governance Factors t * FCF t + ε t Dependent variable: I + t= firm s overinvestment. If overinvestment has been done, its value will be put, otherwise, it will be zero. Independent variables: FCF= the ratio of firm s free cash flow to its assets; and Governance Factors= major ownership, institutional ownership, and board independence. Findings Using fixed effects model and estimated generalized least squares method, the results of testing the model of the first hypothesis are presented in Table 1. Table 1. The results of testing the first hypothesis Variable Coefficients Standard error T statistics Significance level Fixed value Positive free cash flow Negative free

6 cash flow F statistics R-square F statistics significance level Adjusted R-square 0.45 EGSL method (removing possible effects of variance heterogeneity Dourbin-Watson value Given the results of Table 1, since t statistics of positive free cash flow variable is greater than and its significance level is smaller than 0.05, a direct significant relationship exists between positive free cash flow and overinvestment in firms listed in Tehran Stock Exchange. Meanwhile, the variable of negative free cash flow has a direct significant relationship with overinvestment, that is, with a decrease in negative free cash flow, and in other words, with a decrease in the absolute value of negative tfree cash flow investment values, firm s overinvestment is reduced. Thus, there is a direct linear relationship between free cash flow and overinvestment. Therefore, the first hypothesis which states that There is a significant relationship between free cash flow and overinvestment in firms listed in Tehran Stock Exchange is confirmed. Also, Dourbin-Watson statistics of the model is 2.002, which is between 1.5 and 2.5. Also, F statistics significance level is 0.000, which is less than 0.05 and indicates that the model is significant. Another significant point in Table 1 is the adjusted R-square of the model. The value of the adjusted R-square is about 45% indicating that about 45% of the changes of the dependent variable can be explained by independent variables, which is an acceptable value. It is noteworthy that the use of EGSL method has eliminated the effects of possible variance heterogeneity. Using fixed effects model and EGSL method, the results of testing the model of the second hypothesis are shown in Table 2. Table 2. The results of testing the second hypothesis Variable Coefficients Standard error T statistics Significance level Fixed value Free cash flow Board independence Major ownership Institutional ownership Free cash flow* board independence Free cash flow*major ownership Free cash flow*institutional ownership F statistics R-square F statistics significance level Adjusted R-square 0.65 EGSL method (removing possible effects of variance heterogeneity Dourbin-Watson value

7 Given the results of Table 2, since t statistics of free cash flow variable is greater than and its significance level is smaller than 0.05, a direct significant relationship exists between free cash flow and overinvestment in firms listed in Tehran Stock Exchange. Meanwhile, t statistics of board independence variable is smaller than ±1.965 and its significance level is greater than Therefore, there is not a significant relationship between board independence and overinvestment. A similar situation exists for variables of major ownership and institutional ownership. On the other hand, t statistics of the variables of free cash flow*board independence, free cash flow*major ownership, and free cash flow*institutional ownership is smaller than ±1.965 and their significance levels are greater than Thus, the moderating effect of corporate governance mechanisms on the relationship between free cash flow and investments is rejected. Hence, the second hypothesis and its subhypotheses stating that Corporate governance and its mechanisms are effective on the relationship between free cash flow and overinvestments of firms listed in Tehran Stock Exchange, The percentage of major ownership affects the relationship between free cash flow and overinvestment of firms listed in Tehran Stock Exchange, the percentage of institutional ownership affects the relationship between free cash flow and overinvestment of firms listed in Tehran Stock Exchange, board independence affects the relationship between free cash flow and overinvestment of firms listed in Tehran Stock Exchange are rejected. Also, Dourbin-Watson statistics of the model is 1.998, which is between 1.5 and 2.5. Also, F statistics significance level is 0.000, which is less than 0.05 and indicates that the model is significant. Another significant point in Table 2 is the adjusted R-square of the model. The value of the adjusted R-square is about 65% indicating that about 65% of the changes of the dependent variable can be explained by independent variables, which is an acceptable value. It is noteworthy that the use of EGSL method has eliminated the effects of possible variance heterogeneity. Conclusion In this study, the hypotheses were tested based on the data gathered from 116 firms listed in Tehran Stock Exchange during the years 2010 to 2014 and by using panel regression analysis. The results of testing coefficients significance briefly indicated that a direct and significant relationship exists between free cash flow and overinvestment in firms listed in Tehran Stock Exchange and corporate governance mechanisms cannot modify this relationship. The results of testing the first hypothesis can be considered in conformity with the result of BenMohamed et al (2014), Hovakimian and Hovakimian (2009), George et al (2008), and Arsalan et al (2006). Another result of this study has been the lack of an effective monitoring role by major ownership, which is in conformity with the results of Hassan Zade Brothers et al (2012), Bhutta and Ali Shah (2014), and in contrast with the results and arguments of Jensen and Meckling (1976), Ely and Song (2000), Elloumi and Gueyle (2001), Abdullah (2006), Kapopoulos and Luazaretou (2007), Kalatsiz et al (2010), Namazi and Kermani (2008), Esmaeil Zade Maghari et al (2010), and khoda Dadi and Taker (2012). The lack of the significant effect of board independence can also be considered in conformity with the results of Feli (2008), and Izadi Niya and Resaeian (2011), and in contrast with the results and arguments of Fama and Jensen (1983), Zahra and Pearce (1992), Bathala and Rao (1995), Rediker and Seth (1995), Elloumi and Gueyle (2001), Rutherford and Buchholtz (2007), and Esmaeil Zade Maghari et al (2010). The lack of the effect of institutional ownership on the relationship between free cash flow and overinvestment can also be considered in conformity with the results of Bhutta and Ali Shah (2014), and in contrast with Skaife et al (2004), Tasia and Gu (2007), and Khoda Dadi and Taker ( Given the results of testing the hypotheses of the study, stating that a direct significant relationship exists between free cash flow and overinvestment in firms listed in Tehran Stock Exchange, investors in these firms are recommended to consider the positive effects of increasing firm s free cash flow in their analyses as well as considering its negative effects such as increasing overinvestment. It is also recommended to the managers of these firms to make investment decisions with more care, planning, and forethought when increasing firm s free cash flow. Sources: 38

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