A Research Proposal on

“ Does High Free Cash Flow Destroy the Value of

Stockholders?”

Submitted to:
Md. Saimum Hossain
Assistant Professor
Department of Finance
University of Dhaka

Submitted by:
Azizur Rahman Rejvi
ID: 23-163
BBA 23rd Batch
Department of Finance
University of Dhaka

Date of Submission: 28th February 2022

Introduction

1.1 Background of The Study:

Free Cash Flow to the Firm (FCFF)
FCFF is a measure of cash flow that is available for distribution to the fund providers after accounting for
cash operating expenses, working capital investment and capital investments (Adinehzadeh, 2013). Like net
profit, it is also an important measure of financial health and is arguably considered the most important
financial indicator of the intrinsic value of a company.

The FCFF calculation is a measure of a company's performance and operations. All cash inflows in the form
of revenues, all-cash outflows in the form of ordinary expenses, and all cash reinvested to grow the firm is
taken into account by FCFF. A firm's FCFF is the money left over after all of these activities have been
completed.

The most important financial indicators of a company's stock value are free cash flow. A stock's value/price
is calculated as the total of the company's estimated future cash flows. Stocks, on the other hand, are not
always priced correctly. Investors can use the FCFF of a company to determine whether a stock is properly
valued. FCFF also denotes a company's ability to pay dividends, repurchase shares, or repay debt holders.
Checking the FCFF of any company before investing in its stock is very crucial for the shareholders to
maximize their value (V. Kousenidis, 2006).

The formula is:

FCFF = Net Income + Non-cash Charges + Finance Expense (1 – Tax Rate) – Change in Net Working
Capital – Net Capital Expenditure

However, the formula is not mutually exclusive as FCFF can be calculated using different methodologies.
Price to Earnings (P/E) Ratio
Price to earnings ratio, popularly known as the P/E ratio is a valuation methodology that measures the
current share price of a company relative to its earnings per share (EPS) (Mizerka, Czapiewski
• Lizińska, 2015). The resultant quotient is known as multiple and can be used to value similar companies
in an industry or sector.
The price-to-earnings ratio, or P/E, is one of the most extensively used stock analysis methods for estimating
stock value by investors and analysts. The P/E ratio can illustrate how a stock's valuation compares to its
industry group or a benchmark like the DSEX Index, in addition to determining whether it is overvalued or
undervalued. The P/E ratio aids investors in determining a stock's market value in relation to its earnings. In
a nutshell, the P/E ratio indicates how much the market is ready to pay for a stock now based on its previous
or projected earnings. A high P/E ratio indicates that a stock's price is high in comparison to its earnings and
may be overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to
earnings.

Shareholders’ value
Shareholder value refers to the value provided to a corporation's equity owners as a result of management's
capacity to improve sales, profitability, and free cash flow, resulting in higher dividends and capital gains
for stockholders (McClelland & Priest, 2013).

The capacity of a firm's board of directors and senior administration to make strategic decisions, such as
making sensible investments and generating a healthy return on investment, determines its value for
shareholders. The share price rises and the corporation can pay higher cash dividends to shareholders if this
value is created, especially over time.

Firm value is defined as an investor's opinion of a company's level of success, which is usually tied to its
stock price (Dhumale, 2017). If an investor believes there is a high chance of the company succeeding in the
future, the market value of its shares will rise. The company's principal objective is to maximize the wealth
of its stockholders. The wealth of shareholders can be increased by increasing the value of the company.
According to Chang et al., (2007), the market price of the firm's common stock represents firm value.

Bhundia, (2012) conducted research on all the companies listed on the Indian Stock Exchange to examine
and compare the impact of the free cash flows on earnings management. The main objective of the research
was the investigation of the effects of the companies’ free cash flows on the shareholder's earnings and value
generations. In this study, the Regression model and Jones model had been used to conduct the analysis part.
The results of the research indicate that there is a significant positive relationship between free cash flows
and stockholders earnings management and value generations. Thus, the companies with excessive free cash
flows are likely to increase the stockholder's values through earnings management.

Shylvie and Ratnaningsih (2016) conducted a study on “The impacts of free cash flow on the firm value” to
investigate whether high free cash flow to a firm affects the value of the company or not. For conducting
this research, they collected data from the Indonesian Stock Exchange from the year of 2012 to 2014. They
have considered the data of about 331 manufacturing companies that are listed on the Indonesian Stock
Exchange. This study has been conducted by applying different tools such as Descriptive Statistics, Linear
Regression Analysis, Heteroskedasticity test and Multicollinearity test. The results of their study have shown
that the firm value is not positively affected by the free cash flow to the firm. Thus, free cash flow to the
firm does not affect the firm value as well as share shareholders value as a whole in the companies of the
Indonesian Stock Exchange.

Lev and Thiagarajan (1993) researched the underlying factors that influence the firm's value. The firm's
value is maintained by making efficient use of its free cash flow. A company that has information about a
reduction in capital expenditure is not regarded as profitable. It raises doubts about the company's prospects.
The market interprets this as a hint that the manager is anxious about whether the current cash flow is
sufficient to maintain the firm's investment level. A reduction in capital/research and development spending
could be seen as a desire to generate higher profitability for the current quarter. The increase in these
expenditures, once again, indicates that the company's earnings will be sustainable in the future. It manifests
itself in the form of a big and positive stock return and wealth generation. As a result, any significant rise in
free cash flow for a company with high profitability reduces the company's value. The free cash flow should
be properly capitalized to increase the firm's worth, or it might be handed to the investors so that they can
focus on expanding their wealth (Lev and Thiagarajan, 1993). In management accounting, performance
measurement is usually related to cash flow and is carried out using various statistics such as testing
information content abuse as well as accounting figures. Increasing the amount of information in accrual
components of earnings and internal performance measurement, on the other hand, delivers more informative
insights. The link between f and g is investigated in this work. The relationship between free cash flows and
earnings, as well as total shareholder returns, is investigated in this article. The research uses data from the
Tehran Stock Exchange to examine 54 companies. The findings reveal that there was a significant association
between free cash flow, profitability, and all stakeholders' returns. However, this is accomplished by raising
the revenue and cash flow of information asymmetry is proportional to the economic efficiency of
shareholder value (Ghodrati and Abyak, 2014).

Brush et al., (2000) looked into the agency perspective in which sales growth in companies with free cash
flow (but not strong governance) is less profitable than sales growth in companies with no free cash flow.
They also look at whether excellent governance improves the profitability of organizations with free cash
flow and/or limits unprofitable sales growth initiatives. Firms with free cash flow benefit less from sales
growth than firms without free cash flow, which is consistent with agency theory. However, different
governance situations have distinct effects on sales growth and success. Having a large percentage of
management shares in the company reduces the impact of free cash flow on performance while allowing for
faster sales growth. Outside blocks held by mutual funds, on the other hand, significantly decrease sales
growth while having no impact on performance.
According to Iskandar et al., (2012), based on agency theory, ownership structure plays a role in monitoring
management opportunistic behaviour. This research looks at how various ownership structures, such as
foreign ownership, government ownership, and managerial ownership, affect the link between free cash flow
and asset utilization. Companies listed on Bursa Malaysia are included in this cross-sectional analysis. Free
cash flow and asset utilization have a negative connection, according to the results of a hierarchical multiple
regression study. This conclusion suggests that free cash flow may be invested inefficiently, adding to asset
inefficiency. This research has also shown that foreign and managerial ownership offers oversight of the use
of a company's assets, particularly in organizations with significant free cash flow. The findings help
to clarify the significance of various aspects of ownership structure in overseeing the usage of the company
and its assets.

Wang (2010) looked at the relationship between free cash flow (FCF) and agency costs (AC), as well as how
FCF and AC affect company performance. As a result, the research has three goals. The study's objectives
are to investigate the impact of FCF on AC, re-examine the free cash flow hypothesis, and test the agency
theory using empirical data from Taiwan publicly traded companies. Standard free cash flow is used to
quantify FCF, and six proxy variables are used to measure AC in this study. FCF is discovered to have a
considerable impact on AC, with two opposing effects. FCF could incur AC due to perquisite consumption
and shirking behaviour; on the other hand, the generation of FCF, resulting from internal operating
efficiency, could lead to better firm performance. This study finds a significantly positive relation between
FCF and firm performance measures, indicating a lack of evidence supporting the free cash flow hypothesis.
The study provides a better understanding of the association among FCF, AC, and firm performance.

Jones and Sharma (2001) used data on all Australian listed companies to do research on the rapid rise of
"new economy" companies in Australia and compare their levels of earnings management to "old economy"
organizations. The author goes over the relevant study, explains the technique, and then gives the findings.
This shows that companies in the old economy engage in extensive earnings management, which is positively
associated with leverage and free cash flow levels, but that this is significantly less prevalent in the new
economy. Considers the findings' consistency with other studies, as well as the underlying reasons for the
findings, such as regulatory limits and future study prospects.

Chang et al., (2007) investigated the importance of investment opportunities and free cash flow in
understanding the source of the stock valuation effects of secured debt issuance. They discovered a strong
link between a company's investment opportunities and its stock price response to the secured debt offering
announcements. This evidence backs up the investment opportunity hypothesis, which states that secured
debt financing is more beneficial for companies with great growth potential. The free cash flow hypothesis,
on the other hand, received no support. These results stay true even when other potentially important
variables are taken into account. Their research helps to clarify the relative importance of many potential
drivers in explaining variation in the valuation impact of secured debt securities.
Ali et al., (2018) conducted a study and the study's main goal was to find out the impact of free cash flow on
the profitability of companies in Germany's automotive sector. The research used a descriptive survey to
investigate the effect. Furthermore, because a simple random sampling method was being used all businesses
in the automotive industry had an equal opportunity of being studied, only 5 companies were comparatively
identified for the purpose of study from the population available, and the secondary data used for the study
were extracted from the audited annual remittance statements (2007-2016). As a result, the regression
findings revealed a favorable association between free cash flows and the profitability of publicly traded
companies. However, evidence for this comes from evaluating the proxies, which show that leverage has an
inverse negligible influence on profitability (ROA) (Leverage, Current asset, Firm size, Capital liquidity,
Sales growth, FCF). The findings also revealed that R-squared= 0.766504, indicating that the regression
model used in the study is a good predictor, explaining 76.65% of the variation in business profitability
(ROA) which results in enhancing the value of stockholders significantly (Ali et al., 2018).

1.2 Objectives
Free cash flow is one of the effective and significant financial indicators for any companies. But, the
companies who hold high free cash flow rather than investing them or disbursing them to the owners may
result in losing the value of the stockholders tremendously.

➢ The main objective of the report is to find conceptually and statistically whether excessive free
cash flows of the companies destroy the value of the stockholders or not.
➢ The secondary objective of the report is to gather practical and conceptual knowledge and facts
about the impacts of free cash flows on the stockholder's value in Bangladesh.
➢ In addition, another objective is to get a better understanding of the investor’s perspective to
conduct their investment in the companies in Bangladesh

1.3 Scope of The Study

This report will allow us to attain practical and conceptual knowledge about the impacts of free cash flows
on the stockholder's value in Bangladesh. The study holds the FCFF and how significantly it impacts the
value of the stockholders in different companies in different industries in Bangladesh. Besides, the broad
knowledge and understanding about the stockholder's tendency and perspectives to utilize the companies’
free cash flows.
Methodology
The methodology is the tool used to attend the purpose of an investigation; a way of solving problems and
creating knowledge. The methodology is usually divided into qualitative and quantitative methods, which
are distinguished in the way they analyze and treat information (Holme & Solvang, 2007). Quantitative
research should be measurable; the measures are used to describe and explain and aim to generate validity.
Qualitative research is characterized by investigators trying to understand how people experience
themselves, their existence and their environment (Lundahl & Skärvad, 2009).

2.1 Sampling Method and Data Collection

For conducting this research, I have taken around 140 organizations that are listed in Dhaka Stock Exchange
(DSE). Thus, the total number of organizations is 140 which are considered from 14 different industries. All
the data from 140 companies have been collected from the financial year of 2005 to 2020. Thus, this research
will have been conducted by taking the data of the last 15 years of the selected companies If any organizations
become unable to publish their annual reports for a specific year, then it will be considered to omit that
particular year. In this report, I have collected different fundamental data such as operating cash flows, tax
rate, financial expenses, changes in net working capital, net capital expenditures, P/E ratio and free cash flow
to the firm from the annual reports of these companies. Besides, the market P/E multiples, index values and
risk-free rate are collected from Dhaka Stock Exchange (DSE)
2.2 Research Hypothesis
The hypothesis is that having a high free cash flow to the firm (FCFF) per share destroys the value of the
owners. In other words, the business organization that holds the free cash flow rather than investing them
or disbursing them to the owners. Here the companies earn only risk-free rates from the banks but if these
were disbursed, the owners could earn more than this. Thus, holding higher free cash flow leads to the
destruction of the value of the stockholders.

H0 =Free Cash Flow does not have any impact on stockholders’ value

H1 = Free Cash Flow has impacts on stockholders’ value

This Study will be developed in a quantitative point of view. A statistical procedure which includes t-test
Multiple regression analysis, correlation are to be used.

2.3 Variable Selection

For conducting this research paper, the selection and definition of both the independent variable and the
dependent variable are very crucial. The dependent variable is P/E Multiple and the independent variable
is the valuation premium for free cash flow.
𝐹𝐶𝐹 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = (𝑃/𝐸𝐵𝐹𝐶𝐹𝑡 − 𝑃/𝐸𝑇𝐹𝐶𝐹𝑡)
2.4 Research Design
In this project paper where the value of the shareholders is destroyed by high free cash flow will be tested.
This research has been designed to complete in two phases. At first, the impact of the control variable which
is market P/E is to be determined.
𝑃/𝐸𝑇𝐹𝐶𝐹𝑡 = 𝛼 + 𝛽1 ∗ 𝑃/𝐸𝑀𝑡 ……….……………………….………..……….. (1)
Secondly, the same equation will be run along with the independent variable which is the difference
between the P/E of portfolios formed with low FCF per share and P/E of portfolios formed with high FCF
per share. It is also known as a free cash flow premium.

𝑃/𝐸𝑇𝐹𝐶𝐹𝑡 = 𝛼 + 𝛽1 ∗ 𝑃/𝐸𝑀𝑡 + 𝛽2 (𝑃/𝐸𝐵𝐹𝐶𝐹𝑡 − 𝑃/𝐸𝑇𝐹𝐶𝐹𝑡 ) ……. (2)

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