Inter relasionship between capitalstructure, free cash flow, diversification and firm performance

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

ERASMUS UNVERSITY ROTTERDAM
INSTITUTE OF SOCIAL STUDIES
THE NETHERLANDS

VIETNAM – THE NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

INTER-RELATIONSHIP BETWEEN
CAPITALSTRUCTURE, FREE CASH FLOW,
DIVERSIFICATION AND FIRM PERFORMANCE
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

BY
Mr. THAI BA TOAN

Academic Supervisor:
Dr. PHAM DINH LONG

Ho Chi Minh City, December 2016


UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE

THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

INTER-RELATIONSHIP BETWEEN
CAPITALSTRUCTURE, FREE CASH FLOW,
DIVERSIFICATION AND FIRM PERFORMANCE
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS
By
Mr. THAI BA TOAN

Academic Supervisor:
Dr. PHAM DINH LONG

Ho Chi Minh City, December 2016


ASTRACT
Improving firm performance is always a top concern of companies. The global financial
crisis and public – debt crisis in Europe has had a negative impact on the economy of
Vietnam, especially on Vietnamese companies. Therefore, the issues of performance
enhancement, escaping from stagnating production and increasing sales are more
necessary with the company. Besides, the trend of diversification has become more
common in Vietnamese companies. These companies are attracted to investment projects
outside the industry, even these industries are not related to the core business of the
companies. The selection of the investment plan of how, what industries, how combining
funds, or the evaluation of the firm operations to take the right investment are always the
most important issues. The objective of the study was to find evidence of the inter –

relationship between the four factors capital structure, free cash flow, diversification and
firm performance in the Vietnamese market. The study used data from 118 non-financial
companies listed on the Hanoi Stock Exchange (HNX) and Hochiminh Stock Exchange
(HOSE) in the period of 2009-2014. By using 2SLS and 3SLS regression methods,
combined with comparable results from Odinary least squares estimator, the study found
out the evidence of the negative impact of firm performance to leverage, but this impact
is positive to diversification. Free cash flow was also shown to have a positive impact on
the firm performance and diversification. And finally, leverage reduces free cash flow in
a company. From the empirical results, the study also proposes some advices to support
companies in making decisions about capital structure and investment. The study also
points out some of its limitations and futher research.
Keywords: Capital structure, free cash flow, diversification, firm performance, holistic
analysis

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ACKNOWLEDGEMENT
This thesis is the last exercise, which summarized the process of learning and training in
the postgraduate programe for two years. The completed study would not be
accomplished without any supports. Therefore, I gratefully give acknowledgement to all
the assistances and motivations during the time of doing this research as a requirement of
completing my Master Degree of Arts in Development Economics.
Foremost, I would like to sincerely and gratefully thank Dr. Pham Dinh Long, my
supervisor, for his great assistance, principal and valued advice during my thesis finish.
He always stood by me, showed me the passion and the best way to finish my thesis.
Without his counseling, I were not able to accomplish this study.
I would like to thank the Vietnam – Netherlands Programme, especially professors and
staffs for their help during my thesis process. The professors not only gave me the
knowledge but also created the best conditions for me in order to collect data and write

this thesis. The staffs of Vietnam – Netherlands Programme who were very friendly and
kind, always willing to help me on the physical facilities as well as references.
I would like to thank all my friends, who never stopped encouraged and helped me when
I met any difficulties in doing the thesis.
Last but not least, I would like to give my deep gratitude to my family for their sacrifices
to help me not only in studying in Master Degree, but also in my whole life.

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CONTENTS
CHAPTER 1: INTRODUCTION ........................................................................................ 1
1.1. Motivation of the research ........................................................................................ 1
1.2. Research objectives ................................................................................................... 3
1.3. Research contribution................................................................................................ 3
1.4. Structure of the research............................................................................................ 4
CHAPTER 2: LITERATURE REVIEW............................................................................. 5
2.1. The study of the relationship between firm performance, capital structure, free cash
flow and diversification.................................................................................................... 5
2.1.1. Capital structure and firm performance .............................................................. 5
2.1.2. Free cash flow hypothesis ................................................................................. 11
2.1.3. Diversification discount and free cash flow ..................................................... 15
2.1.4. The relationship between diversification and capital structure ........................ 19
2.2. Summarize the previous studies about the relationship between the capital
structure, free cash flow, diversification and firm performance .................................... 23
2.3. A holistic framework............................................................................................... 30
CHAPTER 3: METHODOLOGY ..................................................................................... 32
3.1. Model ...................................................................................................................... 32
3.2. Variable decription .................................................................................................. 34
3.2.1. Tobin’s q ........................................................................................................... 34

3.2.2. Free cash flow ................................................................................................... 34
3.2.3. Related entropy and unrelated entropy ............................................................ 36
3.2.4. Total debt leverage ........................................................................................... 37
3.2.6. Advertising expenditure .................................................................................... 38
3.2.7. Working capital................................................................................................. 38
3.3. Data ......................................................................................................................... 38
3.4. Methodology ........................................................................................................... 43
3.4.1. Simultaneous equations .................................................................................... 44
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3.4.2. Two-Stage Least Squares (2SLS) estimator ...................................................... 45
3.4.3. Three – Stage Least Squares (3SLS) ................................................................. 46
3.4.4. Hausment test .................................................................................................... 47
3.5. Results expectation.................................................................................................. 47
3.5.1. Effect of free cash flow, diversification and leverage on firm performance .... 47
3.5.2. Effect of leverage to free cash flow of the company ........................................ 48
3.5.3. Effect of free cash flow, company performance and leverage to the
diversification of the company ................................................................................... 48
3.5.4. Effect of diversification and company performance to leverage ...................... 48
CHAPTER 4: RESULT ..................................................................................................... 50
4.1. Effect of free cash flow, diversification and leverage to company performance ... 50
4.2. Effect of leverage to free cash flow of the company .............................................. 53
4.3. Effect of free cash flow, company performance and leverage to the diversification
of the company ............................................................................................................... 55
4.4. Effect of diversification and company performance to leverage ............................ 60
4.5. Inter – relationship among leverage, free cash flow, diversification and firm
performance .................................................................................................................... 63
CHAPTER 5: CONCLUSION .......................................................................................... 65
REFERENCES .................................................................................................................. 69

APPENDIX ....................................................................................................................... 73

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LIST OF TABLES
Table 2. 1: Summary the previous theories and studies .................................................... 25
Table 3. 1 : Sample statistic ............................................................................................... 40
Table 3. 2: Variable descriptive statistics .......................................................................... 41
Table 3. 3: Spearman and Pearson correlation .................................................................. 42
Table 4. 1: Results of regression equations of firm performance (eq. 1) .......................... 50
Table 4. 2: Results of regression equations free cash flow (eq. 2) .................................... 53
Table 4. 3: Results of regression equations related entropy (eq. 3) .................................. 55
Table 4. 4: Results of regression equations unrelated entropy (eq. 4) .............................. 55
Table 4. 5: Results of regression equation debt leverage (eq. 5)....................................... 60

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LIST OF FIGURES
Figure 2. 1: Summary of separate research related to capital structure, free cash flow,
diversification and firm performance ................................................................................ 30
Figure 2. 2: Holistic framework for capital structure, free cash flow, diversification and
firm performance ............................................................................................................... 31
Figure 3.1: Number of companies which devided by diversified types and stock
exchange ............................................................................................................................ 39
Figure 4.1: Inter – relationship among leverage, free cash flow, related diversification and
firm performance ............................................................................................................... 63
Figure 4.2: Inter – relationship among leverage, free cash flow, unrelated diversification
and firm performance ........................................................................................................ 63

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CHAPTER 1: INTRODUCTION
1.1. Motivation of the research
Vietnam is one of the few countries that was less affected by the global financial crisis in
2008, and is said to still maintain economic growth in a positive way. However, more or
less, Vietnam is yet not able to avoid the negative impacts of this financial crisis storm;
as the panorama of Vietnam’s economy has recently deteriorated and started to slow
down. In addition, the public – debt crisis in Europe also contributed to the growth of our
country's GDP with the GDP in the period after 2008 much lower than the pre - crisis
one. According to the General Statistics Office of Vietnam, Vietnam’s GDP in 2014
increased by 5.98%, compared to this indicator in 2007, which was 8.46%. Besides, the
high inflation rate leads to tight monetary policy of central banks, meanwhile, the sudden
increase of lending rates has brought about numerous difficulties to the firms in raising
capital to expand their either production or investment for potential new projects
In this situation, the Vietnamese firms have become the most serious “victims” which
were negatively influenced by the financial crisis and public - debt crisis in Europe.
Manufacturing and business suffered from the pressure resulting from the economic and
political instability worldwide as well as domestic such as the existence of bad debts, the
difficulties in goods consuming, or the ability of fund disbursement was still low, etc. In
recent years, a number of companies failed to continue operations because of daily losses,
ended up bankruptcy. In this tough situation, many companies needed to change to
survive. These companies have chosen to restructure the capital structure, or invest in
other factors to minimize business risks, as well as have verity production, etc. Whether
implementing any business strategies, companies’ top priority is focused on improving
firm performance, withstanding and overcome the crisis repercussion. Therefore, which
factors and how they impact on firm performance are the most essential points that
companies need to pay attention to.

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There have been multiple studies aimed for finding out exactly what factors and these
factors’ effects on the firm performance, and one of the most highlighted directions is the
consideration of the change in firm performance in relation to free cash flow, capital
structure, and firm diversification. Many economists have pointed out there is a strong
correlation between these factors, but how they interact with each other was still a
controversy. Modigliani and Miller (1958) argued that capital structure did not affect the
firm value, but in the author’s own study in 1963, the authors confirmed the firm value
could be determined by the capital structure of company. Tang and Jang (2007) with the
trade – off theory between equity and debt, or Myers and Majluf (1984) with pecking order theory... also had the valuable research on the relationship between capital structure
and firm performance. The relationship between leverage and diversification was also
analyzed in the studies by Taylor and Lowe (1995), Kochhar and Hitt (1998), Markides
and Williamson (1996) and La Rocca et al. (2009). However, the comprehensive study of
the relationship between these four factors was still limited and the problem has not been
fully exploited.
Capital structure, free cash flow, diversification and firm performance have important
implications in the survival and development of companies. Therefore, the results of this
study may be helpful for companies listed on the stock market in particular and
Vietnamese companies in general in determining the proper capital structure, in line with
long-term orientation of company, or using the cash sensibly, avoiding the cash holding
expense while still maintaining the ability to invest in potential new projects. Moreover,
the clarification of the relationship between diversification and firm performance would
be useful for companies in the implementation of diversification strategies in production
or business.
In the world in general and Vietnam in particular, there were a lot of studies which
research the relationship between capital structure and business results in the company,
but the relationship between these factors with the diversification has not yet been

extensively researched, therefor this research focused on the inter-relationship between
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capitalstructure, free cash flow, diversification and firm performance, research and find
out whether there are any relationship in a holistic situation among these factors in
Vietnamese companies.

1.2. Research objectives
In order to find out the relationships between firm performance, capital structure, free
cash flow and diversification, the study focus on two goals basically:
1, Examine the single relationships of the four factors: capital structure, free cash
flow, diversification and firm performance of companies in Vietnam.
2, Consider these relationships in a holistic situation.
The study poses the following questions in order to serve the research objectives:
1, Whether the capital structure, free cash flow, diversification and firm performance
have the relationships with each?
2, Whether the relationship of these four factors change when they are put into the
relationships with financial factors and the company's strategy?

1.3. Research contribution
For the companies, the relationship among the four factors of firm performance, capital
structure, free cash flow and diversification is one of the leading concerns. Therefore, the
study about these factors in the binding relationship has an important meaning. An
optimal capital structure can help companies maximize firm value, ensure immediate
investment capacity while reduce the risk of bankruptcy. On the other hand, a company
with positive and stable cash flow is a company expresses excellent financial health, with
the possibility of funding for potential projects without borrowing more external capital,
resulting in reduction of time raising capital as well as to maintaining a stable financial
structure. However, a large free cash flow can pose potential negative impacts to the

company, especially the issue of agency. In addition, the economic context is more
volatile as today, more and more companies diversify production and business in order to
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maximize profit and minimize risk. However, whether diversification is an opportunity or
a trap remains a big question. Stemming from the above practices, understanding the
relationship among firm performance, capital structure, free cash flow and diversification
can serve as a basis, a foundation for Vietnamese companies to build the fiscal policy and
business strategy, reasonable investment to maximize firm value. The research will also
contribute to the debate around the world about the relationship among free cash flow,
capital structure, diversification and firm performance.

1.4. Structure of the research
The study is divided into five main sections:
Chapter 1: Introduction. This chapter presents selected topic reason, research objectives,
research distribution and study layouts
Chapter 2: Literature review. This chapter presents the theories and previous empirical
studies about the relationship among the capital structure, free cash flow, diversification
and firm performance, the findings, debate as well as limited in these studies.
Chapter 3: Research methodology. This chapter will present details of the research
model, the variables in the model, data as well as expectations for the results of research.
Chapter 4: Results. This chapter presents and discusses the results of research on the
relationship between the capital structure, free cash flow, diversification and firm
performance in Vietnam.
Chapter 5: Conclusions. This chapter presents the contribution of the research, the next
research and limitations of the study.

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CHAPTER 2: LITERATURE REVIEW
2.1. The study of the relationship between firm performance, capital
structure, free cash flow and diversification
So far, there have been so many economists with a lot of scientific researches on the
relationships between firm performance, capital structure, free cash flow and
diversification. However, most of these studies have considered the relationships
individually and independently; there is a lack of papers which prove the existence of
these relationships in a comprehensive and holistic way. Most of the previous studies
only proved the relationship between two out of the four factors: firm performance,
capital structure, free cash flow and diversification. Therefore, in this chapter, the paper
will also look back on the previous studies of the relationship of each pair of factors.
2.1.1. Capital structure and firm performance
Postulate I of Modigliani and Miller (1958) suggested that the total stock value of a
company can be determined only by real property, thus dividing the cash into different
lines cannot change the total value of securities of that company. This also means that the
capital structure does not affect the firm value. However, the extended postulate I,
Modigliani and Miller (1963) have reversed this statement. Considering the existing tax,
the value of the company achieves maximum levels when it is funded entirely by debt.
Therefore, to understand the relationship between capital structure and firm performance
(representing the value of company), this section will take the three theories: Trade – off
theory, Pecking – order theory and Agency theory into consideration.
The trade – off theory suggests that the company must be trade – off between benefits
from tax shield and costs of financial exhaustion. The tax shield makes the debt become a
raising capital form which is less expensive than equity. However, a high debt ratio leads
to a higher risk of financial exhaustion, even a higher bankruptcy risk. Therefore, the
trade - off theory argues that companies will set a target debt ratio determined by
optimizing the tradeoff between benefits of tax deductions and the cost of debt or
5

bankruptcy costs. Optimal capital structure is a level of debt where marginal benefit of
debt equals the marginal cost of debt, and the firm performance is maximized. Trade –
off theory also said that the target debt ratio in every company is different. Firms with
more safe tangible assets and much taxable income should increase the debt ratio target to
increase the benefits from the tax shield. In contrast, the company is ensured by largely
intangible assets and the less profitable should rely primarily on equity. Tang and Jang
(2007) was based on the research of Ferri and Jones (1979), Castanias (1983) to consider
the role of theory in the research of corporate capital structure. The authors made seven
hypotheses to clarify the relationship between fixed assets, the growth opportunity and
capital structure of the company: first, fixed assets have a positive impact on long-term
debt; second, the growth opportunity has a positive impact on long-term debt; third the
effect of the interaction term for fixed assets and growth opportunity on long-term debt is
positive; fourth, income volatility has negative relationship with long-term debt; fifth,
firm size has a positive relationship with long-term debt; sixth, agency costs have a
positive impact on long-term debt of the company; and ultimately, profitability has a
negative impact on long-term debt. The study used data from 27 hotels and 27 software
companies in 1997-2003. Results showed that there were positive impacts of both fixed
assets, growth opportunity and interaction term for fixed assets and growth opportunity
on long-term debt in the hotel companies. By contrast, in the software companies, the
negative relationship between growth opportunity and long-term debt was found.
Bradley et al. (1984) also found evidence for the hypothesis of the theory. The authors
used data from 851 companies of 25 different industry groups, which are divided
according to the first two-digit of Standar Industry Classification (SIC codes), in the
period of two decades from 1962 to 1981. This paper reviewed the previous studies on
the optimal capital structure and carry out the verification of the existence of the
hypothesis of trade – off theory. The empirical model had combined the individual taxes
from investors on their income from stocks and bonds, the expected cost financial distress
and non-debt tax deduction. The authors also made seven hypotheses about risk

6


preferences of investors, environmental taxes used in the research, the combination of
non-debt tax benefits on the capital structure decisions of companies and the prevention
of corporate bankruptcy cases. By using Analysis of Variance (ANOVA) with industry
dummy variables, the study gave the evidence of the existence of the hypothesis of tradeoff theory. The authors pointed out that the optimal leverage of the company has a
negative relationship with the expected cost financial distress, and non-debt tax benefits.
At the same time, the optimal financial leverage also negatively related to corporate
income if the expected cost financial distress of the company exists.
Kester (1986), Titman and Wessels (1988), Rajan and Zingales (1995) also gave
empirical evidence proving negative relationship between leverage and firm performance.
Rajan and Zingales (1995) studied the choice of the capital structure of the companies in
the G-7 countries (the United States, Japan, Germany, the United Kingdom, France,
Canada, and Italy). The authors collected data from the 4,557 non-financial companies
which belong to the main industry groups in these countries in the period of 1987-1991
reported in Global Vantage, then sort them based on the financial indicators in 1991. The
authors measured the leverage by four ways: first, leverage is defined as the ratio of
nonequity liabilities to total assets, where nonequity liabilities are the sum of the all
liabilities and total assets are the book value of total assets. Second, leverage is calculated
as the debt divided by the total assets, where debt is the sum of long-term and short-term
debt. Third, leverage is measured as the value of debt to net assets where net assets are
the assets minus accounts payables and other current liabilities. The last, leverage is the
ratio of debt to capital, where capital is the sum of debt and equity. There are three
reasons why the authors measured the leverage as many different definition. First of all,
the consolidated balance sheet was not required to report for some contries; hence some
companies which did not report their consolidated balance sheet would show to have
lower leverage than otherwise similar companies which reported consolidated balance
sheet. The second reason is the appraisal of assets may be different significantly across
countries. Third, the difference about the structure of the balance sheet, which is what

7


items are in and not in different countries. The research computed and compared the
mean of the leverage of each contries to make the conclusion about the decicions in
capital structure in different contries. The evidence showned that there was not much of
the different in capital structure decisions of companies in different countries. Next the
authors estimated the equation with dependent variable, the leverage; the independent
variables include fixed assets, firm performance (Market to book is the ratio of the book
value of assets minus the book value of equity, plus the market value of equity, all
divided by the book value of assets), firm size and corporate profitability for each
country. At the results, the positive relationship between fixed assets, firm size and
leverage were found. In contrast, Market to book and profitability variables were proven
negative impact on leverage. To explain the inverse relationship between leverage and
firm performance, the authors used the trade-off theory to argue that the company with
high level of Market to book ratio would have the high cost of financial distress;
therefore, these companies tended to reduce financial leverage as a precaution for the
future.
On the other hand, according to the pecking – order theory, the managers obviously are
aware of both the potential risks as well as the value of the company rather than
investors, so in order to minimize asymmetry information between managers and
investors as well as minimize the financial costs, company should finance their
investments with retained earnings firstly, then by the safe debt, risky debt, and
ultimately release new shares. Myer and Majluf (1984) argued that there is no optimal
capital structure for the company. Research shows that the investors tend to want to
reduce the price of new shares issued by the company and this is also in line with
forecasts by the managers. Therefore, to prevent investment decisions being negative
towards intervention, the managers will prefer to use internal funds than external sources
such as debt or new equity. According to the pecking - order theory, the attraction of the

tax shield is only second. The debt ratio will change whenever there is an imbalance
between internal cash flow, dividends and real investment opportunities. Companies with

8


high profitability will tend to use less debt leverage or a capital with lower debt ratio than
other companies in the same investment opportunities. In addition, Myers and Majluf also
said that in addition to the current costs, companies also consider the cost can be incurred
from investing in the future. The balance cost of current and future businesses can help
company accumulate cash to carry out new potential investment without having to
borrow money with high interest or even to release more equity. Therefore, with other
impacts are constant, the company has great potential investment will maintain a lowrisky debt ratio and consequently, the current leverage will also lower than other
companies. This theory explains the negative relationship between profitability and debt
leverage. Research of Ross (1997) gave a signal effects to explain the actions of
companies and investors on the stock market. According to Ross (1997), a company with
high debt levels will emit a signal to investors that the future cash flows of the company
are high quality. Explaining this, the author suggested that only good quality companies
have the ability to solve the debt and a large interest well. Therefore, if a company is
required to issue new equity, i.e. the cash flow of the company is no longer able to handle
the debt, so that would be a negative signal to investors.
Finally, according to agency theory of Jensen and Meckling (1976) and Jensen (1986),
there is a conflict between managers and shareholders or investors. When financial
excesses exist, managers easily tend to pursue personal goals, wasting free cash flow
rather than using them as efficiently such as investing in poor - quality projects even it
might reduce the value of company. This is called over – investment problem. To reduce
the over – investment problem, the power of managers in determination in cash flow
should be limited thought borrowing debt. Debt force companies to pay cash, thus
reducing the amount of cash held in the company. A good level of debt is level where
after pay out the interest to creditors, the company will be only enough money to invest

in projects with positive NPV. Therefore, agency models explain the positive relationship
between leverage and firm performance.

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Beside these above theories, the relationship between capital structure and firm
performance is also reflected through the relationship between Tobin's q and debt
leverage. Smith and Watts (1992) started a controversy when they said that Tobin's q is
an exogenous variable while leverage is the endogenous variable. McConnell and Servaes
(1995) did not agree with this conclusion and confirmed that leverage is an exogenous
variable and Tobin's q is an endogenous variable. Meanwhile, studies of Rajan and
Zingales (1995), Demsetz and Villalonga (2001), De Jong (2002) and Harvey et al.
(2004) have considered both variables are endogenous, i.e. the interaction between these
two variables, so that the capital structure has an important influence on the firm
performance and opposite, firm performance also has an impact on the capital structure.
Harvey et al. (2004) studied the effect of of debt on the reduction in the agency and
information problem. The authors consider interaction effects, i.e. the endogenous
relationship between debt, the ownership structure and corporate value. The author has
clarified this relationship by two regressions: Cross-sectional analysis to test the role of
debt in mitigating the reduction in corporate value in the company with the separation of
management control rights and ownership rights of the cash flow, this means whether
leverage can be used to reduce the negative impact of the agnecy problem on corporate
value. Second, the event-study analysis found evidence about the differences in the
abnormal returns associated with debt issued in different markets. For cross-sectional
analysis, the authors collected data from 1,014 exchangelisted non-financial firms in
eighteen emerging markets in 1995-1996. Experimental results shown that debt lessened
the reduction in firm value that follow a separation between a management group’s
control rights and its proportional cash flow ownership. For the event-study analysis, the
authors used data of 547 exchangelisted non-financial firms in twenty emerging markets

in Worldscpoe over the period of 1980-1997. The author has demonstrated that the
international loans earn positive cumulative aberrant returns. These cumulative aberrant
returns are positive affected on the separation of control and ownership. This positive
relation is focused on firms with a high level of assets or less growth opportunities. Initial
issues of public international bonds led to significant aberrant returns, but these returns
10


are not matched with management ownership structures. Therefore, this research
determinded these two variable in the endogenous relationship, it means that capital
structure and firm performance interacted to each other.
2.1.2. Free cash flow hypothesis
For decades, there are a lot of methods have been devised to estimate free cash flow of a
company:
According to Lehn and Poulsen (1989), operating cash flow of assets is used as a tool to
measure the free cash flow. Accordingly, free cash flow is simply the excess level of cash
flow. However, this method revealed many weaknesses such as not taking into formula
the investment opportunities of the company. According to Brush et al. (2000), free cash
flow only appear when Tobin's q is smaller than one i.e. when it, the company has a lack
of profitability investment opportunities. Brush et al. (2000) suggested that the free cash
flow is existing if and only if companies have fewer opportunities to develop. This
method is somewhat improved when calculating additional investment opportunities of
companies in free cash flow. However, it has a defect that cannot combine the investment
with current assets, which means that a company has fewer investment opportunities
should focus on their core business by invest in current assets. According to Arslan and
Karan (2007), free cash flow is estimated as the difference between operating cash flow
and capital expenditures divided by total assets. An advantage of this method is that
capture the company's investments directly. However, its shortcomings are ignored
capital expenditures include investments in existing assets and new investment
opportunities, so cash flow is estimated by this method could be depreciation. Zhao et al.

(2009) have improved methods of Arslan and Karan (2007) to give the new formula to
measure free cash flow. Accordingly, free cash flow is defined as the difference between
operating cash flow and capital expenditure per capita in three years divided by total
assets to seize the optimal investment. However this is also a form of extension methods
of Arslan and Karan (2007), it has not been fully resolved the weakness of this method.

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To solve the limitations of previous methods, Richardson (2006) has given a new
definition for free cash flow. The author did the research to indentify the effect of free
cash flow on onver-investment in companies. The research gave the primary hypothesis
is that the company with positive free cash low trend to over – invest. Opening the study
author provided a definition for free cash flow and over-investment; specifically,
according to the author, free cash flow is surplus of the cash flow after spending for the
maintenance of existing assets and funding for expected future project; over- investment
is investment expenditure surplus after financing for the maintenance of existing assets
and expected new positive NPV projects. More specifically, the author defines the total
investment expenditure is the sum of Investment to maintain existing assets in place,
expected investment on new projects and Over-investment in new projects.
Total
Invesment

Investment to
=

Expenditure

maintain existing
assets in place

Expected
+

Investment on
New projects

Over investment
+

in
New project

The author also gives the formula for calculation of Free Cash Flow is the subtraction of
Cash Flow generated from assets in place (CFAIP) and Expected new investment (I*NEW).
Where, CFAIP is calculated from Cash from operating activities (CFO) minus
Maintenance Investment Expenditure (IMANTENENCE) plus Research and Development
Expenditure (R&D).
FCF = CFAIP - I*NEW
CFAIP = CFO - IMANTENENCE + R&D
To estimate the cash flow from the growth opportunities, Richardson (2006) used the
expected investment on new projects and firm level investment decision model of
Hubbard (1998). This method may seem complicated but it is the most reasonable
method to determine free cash flow because it considered all the components of free cash
flow at the company level. The authors have used pool with Huber-White standard errors
regression for sample data include 58,053 firm-year observations during the period of
12


1988-2002 (the financial companies were ignored) to clarify the relationship between free

cash flow and over - investment. The results gave evidence that company with excess
free cash flow is more likely to over-invest on average and then it more over-invest with
more bonus excess free cash flow. Then, the author divided into two groups of companies
based on the level of free cash flow (positive free cash flow and negative free cash flow).
The author has used calculating average using of free cash flow for each of purpose in the
compamy including over investment, payments to shareholders (i.e., pay dividends or
repurchase stock), payments to bondholders (i.e., pay interest or repurchase debt),
retained in financial assets (the cash balance increases) and other purposes. Experimental
results shown that the company with positive free cash flow used a large percentage of
free cash flow for over investment (20% of free cash flow) and retained in financial
assets (40% of free cash flow). Conversely, company with negative free cash flow used
most of its free cash flow to the payment to shareholders (37% of free cash flow) and
payments to bondholders (31% of free cash flow). The other governance analysis also
concluded that the presence of shareholders in corporate management apparatus can
reduce overinvestment.
As the above hypothesis, the financial excess may lead to a negative impact on firm
value. Managers are easy to use cash wastefully, investing in inefficient projects; pursue
personal goals without regard to the interests of investors. Brush et al. (2000) found
evidence that the cash flows themselves have a positive impact on firm growth, but
between free cash flow and firm growth have a negative relationship. The authors have
studied the effect of free cash flow to sales growth of the company as well as the
influence of free cash flow to firm performance. The paper also examined the change of
the impact of free cash flow on sales growth and firm performance when placing it in the
the control company governance (strong or weak). Two issues were studied which started
from Agency and governance theories is that, first, company with high free cash flow but
weak governance would have high sales growth and second, high sales growth led to a
decrease in firm performance. To clarify these two issues, the study has set out six

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hypotheses, including four hypotheses related to firm performance were: 1, sales growth
has a negative impact on firm performance; 2, the positive impact of sales growth on
corporate performance will be reduced in the company with high free cash flow; 3,
Governance controls moderate the extent to which free cash flow reduces the relation
between sales growth and performance; and 4, for company with high free cash flow and
weak governance, sales growth has negative impact on firm performance. And the last
two hypotheses related to sales growth include 5, total cash flow had a positive impact on
the sales growth and 6, the company with strong governance controls, cash flow has less
positive impact to sales growth. The paper used data from Compustat annual report. After
excluding observations missing data or inconsistent data, the final data sample consists of
1,570 firm-year observations in the 8-year period from 1988 to 1995. The results
indicated that the cash flow effected positively to sales growth and sales growth had a
positive impact on firm performance in the case of company with no or little free cash
flow. Large free cash flow would increase sales growth but reduces the value of the
company. The impact of all kinds of different strong governance to sales growth and
performance is different.
Fairfield et al. (2003) and Titman et al. (2004) also demonstrated that stock returns of
company in the future will decrease if the company has too much financial excess.
Similar results are also given by Dechow et al. (2008) when the authors showed that the
large excess cash flow will reduce firm performance in the future. Dechow et al. (2008)
defined free cash flow consists of 3 components: 1, the change in the cash balance; 2, net
cash distributions to shareholders and 3, net cash distributions to debt holders. Therefore,
the positive or negative free cash flow might stem from the increase or decrease in the
cash balance or contribution from shareholders as well as bondholders (from the issuance
of new equity shares or debt, or a change in the policy of payment of dividends, interest,
stock or debt repurchase). The authors gave three predictions for the research included: 1,
the cash flow from retained earnings volatility than capital from equity and debt. The
second prediction was that the cash flow from equity more stable than cash flow from

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debt. And the last prediction was that the expect return from stock prices fail to fully
reflect the high volatility of cash from firm retained earning and the higher constant of
cash from equity. The full sample data of the study was 237,673 firm-year observations
with full data in financial statement data and 155,280 firm-year observations with full
data in financial statement and stock return in the period of 1950-2003. The authors used
annualized regressions following the approach of Fama and Macbet (1973) to clarify
these predictions. The results indicated that the prediction 1 and 2 are absolutely right in
both companies with negative of positive free cash flow. However, the experimental
results were not consistent with the third prediction was that the investors simply fixate
on earnings and fail to tell the difference between accruals and cash flows. In addition,
the authors also said that if company has a large positive free cash flow, it would spend
the most of them to its future investment which can gain the lower marginal profitability
and therefore which would reduce the company value.
Therefore, reducing the free cash flow will increase the firm value through the reduction
of agency costs. In order to reduce free cash flow, corporate restructuring funds with
higher ratio of debt, it means that the repayment obligations also increased, lead to the
reduction in cash holdings, thereby reducing power of the managers in the investment
decision. This confirms that the leverage reduces free cash flow. Park and Jang (2013) in
their study also found the negative relationship between leverage and free cash flow. The
authors suggested that the leverage will increase firm performance but reduces the cash
flow.
2.1.3. Diversification discount and free cash flow
The diversification strategy can be divided into two forms: related diversification and
unrelated diversification. When a company implements the related diversification
strategies, the company will invest in the new business which has more characteristics
similar and familiar with the core business of company. Although investing in a different
industry, company can share costs and technology with its core business. Conversely,

when company invests in a completely different industry; there is no similar and familiar
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or obvious connection with the core operations of the company, it call unrelated
diversification.
Diversification discounts is defined that value of company or company performance
declined after the company implemented a diversification strategy. The researchers said
that the cause of the diversification discount can be agency problem. Lang and Stulz
(1994), Berger and Ofek (1995), Comment and Jarrell (1995) studied and provide
evidence to support the free cash flow hypothesis of Jensen (1986) for the diversification
discount. Thus, agency theory also provides an explanation for why diversification may
be beneficial for managers but reduce the value of the company. Finkelstein and
Hambrick (1996) showed a significant correlation between diversification and company
size and between diversification and management compensation. According to the
authors, managers often wish to pursue diversification as a way to increase compensation
for themselves and consolidate their position; even diversification strategies can reduce
the firm value.
There is lots of debate about the effectiveness of the diversification strategy into the firm
performance. Whether diversification increases the value of company? According to
Rumelt (1974, 1982), unrelated diversification makes the firm performance lower than
related diversification because unrelated diversification requires the company spends a
large initial investment to enter a new business environment, while also potentially more
risk. This will be detrimental to firm value. Villalonga (2004) presented evidence that
unrelated diversification makes a devaluation, while the related diversification takes
company a premium. The author argued that the data used from Compustat data base of
the previous studies made the results inaccurate and did not fully explain the role of
diversification on firm performance. According to the author, there were three main
reasons are as follows: first, the degree of separation into different segments in the
financial statements of the company was lower than the level of the actual diversification

of the company. Second, the definition of segmentation has led to the diversification in
the report shrunk than fact. In particular, The Statement of Financial Accounting
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Standard (SFAS) 14 defined segments as part of the company engaged in providing
products and services to unaffiliated customers group for a profit. Accordingly, it is
understandable SFAS 14 defines segment operating as an unrelated diversification of the
company. Third, company might change its report about its segment, although there were
no real changes in its operations. To find out the answer to the question whether segment
data increased diversification discount than other data sources; the authors used the data
from the Business Information Tracking Series (BITS), analyzed and compared the
results with previous studies, which used segment data from Compustat. The research
defined business establishment as a single physical area where company is administered
or where services or industrial operations are accomplished. And the firm's
establishments have the same SIC codes were grouped together which called business
unit. According to this definition, the author implied that company had not only choice in
unrelated diversification strategy but also in the fact that it performed related
diversification. The author estimated the value of excess value in diversification company
compared to the nondiversification company by mean difference between two types of
companies. In addition, the author also conducted a number of robustness checks to
strengthen results. From the empirical results, the author concluded that unrelated
diversification gave company a discount but related diversification brought company a
premium. This may stem from the argument that unrelated diversification is the result of
over – investment that a deeper reason is due to the financial excess. Doukas and Kan
(2004) confirmed a direct relationship between the discount in the diversification strategy
and free cash flow. The authors suggested that if managers feel free cash flow in the
company is high, they will arise intend to use that cash flow by investing in projects with
negative NPV. In this case, they should consider diversifying both related and unrelated.
Unrelated diversification gain more benefits for the managers, however, they are attracted

by the related diversification due to the ease and familiarity with the core business areas
of company industry. So we can make a conclusion that the diversification whether any
case would also reduce the value of the company if it stems from a financial excess.
Under this negative impact, the management probably will not be possible to make
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