Overinvestment of free cash flow in emerging market firms: An empirical analysis

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Southern New Hampshire University
Free cash flow overinvestment stemming from agency conflicts and moderators of this relationship have been empirically confirmed in several studies for developed markets. Research on emerging market firms has however produced less coherent results. While it can be argued that these incongruities are a consequence of the samples analyzed and the methodologies applied, they might also be rooted in the theoretical underpinnings: Agency theory originates from developed market research, consequently assuming an institutional environment as well as firm characteristics different from those observed in emerging market companies. This study empirically evaluates the investment behavior of a sample of emerging market firms with a methodology that specifically allows a test of the agency-based explanation of excess investment. The findings support overinvestment as a function of free cash flow, thereby confirming the free cash flow hypothesis in emerging market firms. Additionally, the results propose that this relationship can be negatively moderated by corporate governance mechanisms as well as ownership concentration; suggesting (similar to developed market firms) a principal -agent conflict motivated overinvestment. Debt as a “traditional” way to mend this agency problem can however not be confirmed. Furthermore, the study provides empirical evidence for a moderating effect of the institutional environment on the free cash flow overinvestment relationship via its interaction with firm characteristics. This proposes that the two are interrelated and that agency theory might not be invariant to the specific institutional setting. (Author abstract)