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Free Cash Flow with a Firms Capital Expenditure


Free cash flow and capital expenditure go side by side. What is important to find out is the existence of an association between the two in Sugar Industry of Pakistan by means of ascertaining the strength of their relationship.

Annual financial statement data for 27 sugar mills of Pakistan, listed on Karachi Stock Exchange (KSE), was taken to calculate free cash flow and annual capital expenditure over the 2000-08 period. Linear regression test was run on the data to study the relationship between the two variables. The results hence proved an association confirming an existence of a relationship.


Overview of the Sugar Industry of Pakistan –

Pakistan is the 5th largest country in the world in terms of area under sugarcane cultivation, 11th by production and 60th in terms of yield. Sugarcane is the primary raw material for the production of sugar. Since independence, the area under cultivation has increased more rapidly than any other major crop at around one million hectares. The sugar industry in Pakistan is the 2nd largest agro based industry comprising 81 sugar mills out of which 27 are listed on Karachi Stock Exchange. The annual crushing capacity of the industry is over 6.1 million tones. Sugarcane farming and sugar manufacturing contribute significantly to the national exchequer in the form of various taxes and levies. Sugar manufacturing and its by-products have contributed significantly towards the foreign exchange resources through import substitution. Sugar production is a seasonal activity. The mills, at an average operate for 150 days a year whereas the supplies are made throughout the year. As the industry now has large daily crushing capacity there are efforts to reduce the production even further.

About the subject –

The purpose of this research is to examine the significance of free cash flow in relation with firm’s capital expenditure. Many researchers have studied the relationship built around free cash flow and have argued that managers have to play a vital role in deciding where free cash flow eventually ends up. Something known as an agency problem is widely discussed and commented on by several researchers. This problem talks exactly about the conflict of interest between managers and shareholders. Shareholders are interested in earning as much dividends as possible which would increase their value. On the contrary, managers think for themselves. They tend to invest the available cash flow in projects that would not necessarily increase shareholder’s value but ensure that the tenure of the manager is as extended as possible. New investments would mean more responsibilities on managers thus their uninterrupted length of service is required in the long term interest of the firm. Going one step ahead of agency problem, this study is related to free cash flow which shows an association and a relationship with the capital expenditure.

Free cash flow is a measure of financial performance and one of the sources of capital expenditure in firms. Managers can either disburse the available cash among shareholders in the form of dividends after keeping aside the money required to expand or maintain its asset base or hold it back for developing new products, making acquisitions, and reducing debt.

At this point in time, it is imperative to note that negative free cash flow in itself is not bad. If free cash flow is negative, it could show that a company is developing new products, reducing debts or even making large investments. If these cash out flows earn a high return eventually, the strategy has the potential to pay off in the long run.

Capital expenditures (CAPEX) are those cash outflows that create future benefits for the firm. A capital expenditure is incurred when a business outlay funds to acquire or upgrade physical assets such as property, industrial buildings or equipment. CAPEX is commonly found on the Cash Flow Statement as an investment in plant, property and equipment or something similar in the investing section. Companies listed on stock exchange will often list their capital expenditures for the year in annual reports, which allows shareholders to see how the company is using their funds and whether it is investing in its long term growth.

The hypothesis tested in this study is accepted and thus a relationship between free cash flow and capital expenditure is established.

Literature Review

Cash flow is determined by integrating the cash receipt and disbursement items from the income statement with the change in each balance sheet item; the sum of the cash inflows equals the sum of the cash outflows. Whereas capital expenditure is the amount a company spends buying or upgrading fixed assets, such as equipment, during the year and acquiring subsidiaries, minus government grants received.

The free-cash-flow (FCF) hypothesis by Jensen (1986) suggests that excess cash flow is wasted on value-destroying expenditure because managers have a personal motivation to grow the asset base of the firm rather than dispense cash to shareholders in the form of dividends.

Cash flow has always been somewhat of a puzzle in the literature on the determinants of investment. Gugler (2004) argues that in a strictly neoclassical world, cash flow does not belong in an investment equation. Even than pragmatic studies dating back over 4 decades invariably document that cash flow and investment are positively related.

The influence of internally generated cash flow on financing capital investment expenditure is well studied. But what is less well understood is the cause behind this influence. Modigliani and Miller’s (1958) Irrelevance proposition asserts that firms undertake all positive net present value (NPV) investments regardless of the financing source.

Firms that pay low dividends rely more heavily on cash flow as shown by Fazzari, Petersen and Hubbard (1988). The first two gentlemen also found that such firms use working capital adjustments and not external financing to maintain the needed capital expenditure in order to smooth cash flow fluctuations. They further argued that in order to save cash flow, firms choose a low dividend payout policy.

Calomiris and Hubbard (1995) proved that those firms have heaviest dependence on cash flow to finance capital expenditure which pay the highest taxes associated with undistributed profits.

Devereux and Schiantareelli (1990) found that as compared to smaller firms in the UK, the large firms depend more heavily on cash flow financing. The reason they pointed out for such a trend was the manager/shareholder agency problems in these large firms mainly because of lower managerial ownership and higher costs associated with monitoring mechanism.

In this thesis, further evidence have been provided on the role of free cash flow and capital expenditure through observing the data provided by the Karachi Stock Exchange. To measure the market reaction to such expenditure plans, the over and above returns around capital announcements have been used. It was moreover, found that the impact capital expenditure has on firm value that is financed by cash flow depends upon the characteristics of the firm making the expenditures. Firms show a strong positive relation between the level of undistributed cash flow and the level of announced expenditure, although large firms depend less heavily on cash flow as compared to the small firms and those firms that have high managerial ownership.

Jensen (1986) suggested that those firms which had a large level of free cash flow were likely to squander it on unprofitable investments. As a result undistributed cash flow must play an important role in explaining capital expenditure by these firms. In addition, certain firms are more prone to the agency problems of free cash flow, especially the large firms which, as discussed by Devereux and Schiantarelli (1990), generally have a more diverse ownership structure. Jensen (1993) discussed such firms as the ones that have more costly internal control mechanisms. About small firms, Jalilvand and Harris (1986) commented that they are more vulnerable to suffer from cash flow restraint mainly because they have limited access to external captial markets due to higher transaction costs of public security isssues and the information problems. Therefore, Vogt (1997) believes that small firms tend to have profitable and at the same time unexploited investment opportunities. The available cash flow should be the main source of capital expenditure by these firms. Moreover, if cash flow is used by these firms to fund the capital expenditure, such an announcement must show a positive reaction in terms of appreciated stock prices.

Jensen (1986) argues that there are agency costs coupled with free cash flow. His study broadens that argument and speculates that shareholders form their valuation decisions on firms’ reputations regarding free cash flow exploitation. This notion was tested by examining the stock price responses to equity offers, which generally aggravate the cash flow quandary, for firms differentiated by their recent avaricious behavior. The results suggested that shareholders react more positively to equity issue announcements if firms have obtained only assets related to their key business than to other equity issue announcements.

On another occasion, Jensen and Meckling (1976) explained the agency problem between managers and shareholders. They unarguably stated that managers are supposed to be the representatives of the shareholders. But they tend to make those decisions that will maximize their own benefits as opposed to the shareholder’s value. In order to restrict them from doing so, they must either be provided incentives or be monitored. They further argued that in firms where managers have low level of insider ownership, have greater incentives to invest in unprofitable projects that stretch the firms beyond its optimal size and the expected return on new capital expenditure can be negative for such firms. Such actions would obviously be inconsistent with firm’s value maximization objective.

Jensen (1986) suggests that stock prices are tendered downward to imply agency costs coupled with a firm’s free cash flow. In particular, managers have an enticement to use unfettered funds to benefit themselves instead of the shareholders. John and Nachman (1985) claim that agency costs can be alleviated through reputation building. Particularly, they demonstrate that the agency problem of underinvestment can be determined through reputation. The observed results recommend that managers build reputation through covetous activity whereas the shareholders state their response on pre-acquisition activity. In an ideal world, managers would disburse the entire free cash flow among the shareholders provided; the interests of shareholders and managers complement each other. This would maximize shareholders’ wealth and allow them to use the available cash for capitalization. Amihud and Lev (1981) however argued that managers have an enticement to minimize their employment risk. Employment risk aims to explain the insecurity inbuilt in a manager’s tenure or the term of employment. Managers have an option of increasing the certainty of their tenure by diversifying the real asset portfolio of the firm and they do it by purchasing those assets that are unrelated to the primary line of business of the firm. Managers have an option of financing diversification projects by using the free cash flow that has been held back and not been distributed to shareholders, thus they need not seek funds from the capital markets.

Easterbrook (1984) believes that it is easy to watch the managerial behavior of the firms when they seek funds from the well-performing capital markets. Therefore, on one hand it becomes difficult to keep a check on the performance of managers if they use the hoarded cash flow for the purpose while on the other hand, investors are unable to measure free cash flow as they are incapable of scrutinizing the investment opportunity schedule of the firm. Shareholders are expected to take any unencumbered cash request negatively, coming from the management for the purpose of diversifying. Unless they are provided sufficient proof, they will assume the request to be the acquisition of free cash flow. As a result of this ambiguity, stock prices will fall and show the residual loss caused by the probable misuse of free cash flow by management. Further, managers may wish to expand firm size, irrespective of the fact that it increases shareholders wealth or not, based on the assumption that executive promotion and compensation are positively related to firm size (Donaldson 1984; Baker 1986; and Baker, Jensen, and Murphy 1988).

Cash flow is related to the expected return from new investment as shown by Myers and Majluf (1984). Those firms which have a shortage of cash flow and liquid assets might let go profitable investment expenditure instead of issuing mispriced securities to fund the investment. As a result, these firms might have unexploited investment opportunities that would increase firm value if sufficient cash flow could be generated to finance them.

Capital expenditure of high ownership firms must show a dependence on cash flow and positive excess returns must be observed for these firms when they declare new capital expenditure. Morck, Shleifer, and Vishny (1988) described high levels of insider ownership to be associated with high levels of cash-flow-financed capital expenditure because of managerial-establishment issues. Firms with high insider-ownership levels might wish to finance expenditure with cash flow solely to avoid loss of control associated with weakening their ownership position or restrictions imposed by creditors.

Lehn and Poulsen (1989) and McLaughlin, Safieddine, and Vasudevan (1996) defined Free Cash Flow to be operating income before depreciation, less interest expense on debt, less income taxes, less preferred and common dividends.

Vogt (1997) calculated both cash-flow measures net of interest expense and dividends in order to control for managerial decisions affecting the level of undistributed cash flow. Ignoring these other decision variables might create a bias in the observed relation among cash flow, capital expenditure, and market returns. As an example he referred to a firm with high levels of cash flow that does not manipulate the agency problem. Such a firm will minimize undistributed cash flow by choosing high interest and/or dividend levels. It might pursue profitable investment expenditure and is unlikely to rely heavily on cash flow for financing. This firm must be associated with positive market responses around expenditure announcements. Using a cash-flow figure gross of interest expense and dividends would incorrectly combine positive market returns to firms with high cash flow rather than the correct low level of cash flow that it actually maintains.

Vogt (1997) used 421 firms to observe relationship between cash flow and capital expenditure. When these firms announced expenditure increases, the level of announced capital expenditure seemed to be positively and strongly related to the level of cash flow. The strength of this relation increases for firms with profitable earlier investment opportunities, as firm size declines, and as the proportion of insider ownership increases.

His further analysis suggested that considerable diversity exists in the capital market’s response to capital expenditure financed by cash flow. The positive and statistically significant excess returns found in the sample of firms announcing increases is concentrated in the smallest of the sample firms, in firms with low cash flow relative to capital expenditure, and, to a lesser extent, in firms with high levels of insider stock ownership. Tests explaining the cross-sectional variation in returns reveal that excess returns for medium and small firms in the sample are positively associated with unexpected increases in planned expenditure. These tests also suggest that the capital market responds more favorably to the announced expenditure by small firms when the planned expenditure is more dependent on cash flow. On the other hand, excess returns for the largest firms in the sample are negative, however not statistically significant.

Vogt (1997) observed that due to the fact that small firms and high ownership firms are most likely to face the liquidity crunch associated with asymmetric information, they are also the most likely to let go profitable investment opportunities in times of cash flow shortages. As cash flow rises, the set of profitable capital investment projects the firm can carry out also increases. As a result, capital expenditure announcements are met with positive shareholder reactions, particularly when expenditure is dependent on cash flow.

Vogt (1997) concluded by observing that the apparent diversity in the market’s response to capital expenditure decisions suggests different capital expenditure financing policies for firms that seek to augment shareholder value. The market values of small firms, firms with significant insider ownership, and firms that are generally cash flow confined appear to be improved, on average, by financing capital expenditure with cash flow. These firms might consider policies of saving undistributed cash flow through low payout and leverage policies. Such an action therefore encourages new capital expenditure from internally generated funds. However, all other firms seem to be less dependent on a cash flow retention policy to facilitate capital expenditure.

In 1986 while explaining the free cash flow (FCF) hypothesis Jensen (1986), focuses on the agency issue. He argues that managers can increase their wealth at the cost of shareholders by not paying out the funds from a firm’s free cash flow in the form of dividends or debt financed share repurchases, rather investing them in unprofitable investment prospects. Devereux and Schiantarelli (1990), Strong and Meyer (1990), Oliner and Rudebusch (1992) and Carpenter (1993) later studied the role that agency problems play in the cash flow-investment relationship. Their findings turned out to be conflicting vis-a-vis the importance of free cash flow. Strong and Meyer (1990) found that share prices of firms that undertake investment expenditure with unrestricted cash flow experience negative performance while Oliner and Rudebusch (1992) found little evidence regarding ownership structure affecting the cash flow-investment relationship.

The firm’s dividend decision has connotation for the FCF theory. According to Lang and Litzenberger (1989), dividends are one means of eliminating free cash flow. Vogt (1994) developed a model in this research paper where he showed that firms with the opportunity to exploit free cash flow will follow low dividend payout policies and cash flow will have a strong influence on investment expenditure. On the other hand, if firms are confined from obtaining external funds because of whatever reason, those firms with profitable investment opportunities will maintain low dividend payout policies in order to preserve on cash flow. Therefore his model was found to be consistent with Fazzari, Hubbard, and Petersen (1988); it predicts that low payout firms should be associated a strong cash flow-investment relationship.

There has been considerable empirical evidence which indicate that internally generated funds are the primary way of financing firm’s investment expenditures. Gordon Donaldson (1961), in a detailed study of 25 large firms, concludes as follows: “Management strongly favored internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable ‘bulges’ in the need for new funds.”

A later survey of 176 corporate managers by Pinegar and Wilbricht (1989) discovers that managers prefer cash flow to finance new investment over external sources as 84.3% of sample respondents showed their preference for financing investment with cash flow.

Vogt (1994) explains the relationship of cash flow and capital expenditure by analyzing the free cash flow theory of Jensen (1986). As monitoring is assumed costly, and managers can benefit from overinvestment, he predicts that cash flow will significantly influence investment expenditure after controlling for the cost of capital. Investment expenditure of firms not paying dividend will be more influenced by cash flow than investment expenditure of firms that pay dividends. This follows because no-dividend firms are able to retain all cash flow and still not reach the retention constraint. For liquidity-constrained firms, cash flow and changes in the stock of the firm’s liquid assets should have a significant influence on investment expenditure. Firms with many profitable investment opportunities or large information asymmetries will have investment expenditure that is most sensitive to changes in cash flow, and should conserve on cash flow by paying low or no dividends. Firms indicating a liquidity constraint by not paying dividends will have the most significant cash flow/investment relationship.

In a study; Fazzari, Hubbard, and Petersen (1988) discovered that cash flow has a strong effect on investment expenditure in firms with low dividend payout policies. They argue that this result is consistent with the belief that because of asymmetric information costs associated with external financing, low payout firms are cash flow confined. One reason these firms keep dividends to a minimum is to preserve on cash flow from which they can fund profitable investment prospects. Later in the year 1993, Fazzari and Petersen (1993) found that the same group of firms paying low dividends, even out fluctuations in cash flow with working capital to maintain desired investment levels. This result is consistent with the findings done by Myers and Majluf (1984) which states that the underinvestment problem arising from asymmetric information can be alleviated by the liquid financial assets.

Carpenter (1993) studied the relationships between debt structure, debt financing, and investment expenditure to test the theory of free cash flow, comparing the restructured firms with the non-restructured firms. He observed that firms had increased their investment expenditure that was restructured by substituting large amounts of external equity with debt as compared to non-restructured firms. To him these results seemed to be inconsistent with free cash flow behavior. He believed that cash flow committed to debt maintenance must be correlated with reductions in later investment expenditure.

Devereux and Schiantarelli (1990) and Strong and Meyer (1990) conducted studies that support the free cash flow interpretation. Strong and Meyer (1990) studied separately the investment and cash flow of firms in the paper industry into sustaining investment and discretionary investment, and total cash flow and residual cash flow. Discretionary investment and share price performance are negatively and strongly related. Discretionary investment and residual cash flow are found to be positively and strongly correlated. This evidence suggests that residual cash flow is frequently used to finance unprofitable discretionary investment expenditure.

Study conducted by Vogt (1994) related to cash flow and capital expenditure predicts that firms not paying dividends should exhibit the strongest relationship, while those paying high dividends should show the weakest relationship between cash flow and investment expenditure. His result suggested that cash flow-financed capital expenditure is slightly inefficient and provides facts in support of the Free Cash Flow hypothesis. Regarding the small firms that paid low dividends over the sample period, Vogt (1994) commented that such firms relied heavily on cash flow and changes in cash to fund capital expenditure. Cash flow-financed growth by small, low-dividend firms is likely to be value- creating, whereas cash flow-financed growth is value destroying for large, low-dividend firms. He concluded by suggesting that managers of cash flow-rich companies may consider increasing dividend payouts as a method of increasing the efficiency of their capital expenditure decisions. A continued high-dividend-payout policy may also signal to shareholders that extra and expensive monitoring of capital expenditure decisions is unnecessary. Furthermore, since capital expenditures typically add to the amount of assets under managerial control and create more predictable future cash flows, such expenditures generate the opportunity to exploit free cash flow in following periods.

Alti (2003) found out that investment is sensitive to cash flow. The sensitivity is substantially higher for young, small firms with high growth rates and low dividend payout ratios. The uncertainty these firms face about their growth prospects amplifies the investment-cash flow sensitivity in two ways. First, the uncertainty is resolved in time as cash flow realizations provide new information about investment opportunities. This makes investment highly sensitive to cash flow surprises. Second, the uncertainty creates implicit growth options relate to long-term growth potential but not to investment in the near-term. Having a weaker relationship with the value of long-term growth options, cash flow acts as a useful instrument in investment regressions.

Gentry (1990) analyzed capital expenditure with total cash flow and found out that the percentage of cash flows going to capital investment ranged from an outflow of 60 percent or more. The giant companies invested a higher percentage of their total outflow in plant and equipment than companies in the other size categories. The small companies invested the lowest percentage of their total outflows in capital.

There has been a research done previously that was applied to agricultural firms by Jensen (1993). The results were found to be consistent with previous studies for nonagricultural firms which showed that internal cash flow variables are important in explaining investment. It was found that the addition of internal cash flow variables can improve the explanatory power of agricultural investment models. In terms of elasticity, investment was more responsive to internal cash flow variables.

Worthington (1995) has found that cash flow measures industry-level investment equations positively and significantly, even after investment opportunities are proxied by capacity utilization variables. The effect of cash flow is greater in durable goods industries than in non durable goods industries.

Moyen (2004) explained the fact that the cash flow sensitivity of firms described by the constrained model is lower than the cash flow sensitivity of firms described by the unconstrained model can be easily explained. In both models, cash flow is highly correlated with investment opportunities. With more favorable opportunities, both constrained and unconstrained firms invest more.

Raj Aggarwal (2005) conducted a study in which he concluded that investment levels are significantly positively influenced by levels of internal cash flows. Also, the strength of this relationship generally increases with the degree of financial constraints faced by firms. Overall, these findings seem strong to the nature of the financial system and indicate that most firms operate in financially incomplete and imperfect markets and find external finance to be less attractive than internal finance.

Research Methodology

Introduction –

The hypothesis tests the relationship between free cash flow and capital expenditure, concentrating on the Sugar Industry of Pakistan. The aim is to ascertain the strength of the relationship between the variables. In order to do that, linear regression seems to be the best test as it attempts to model the relationship between two variables by fitting a linear equation to observed data. One variable is considered to be an independent variable while the other is considered to be a dependent variable. The objective of multiple linear regression analysis is to use the independent variables whose values are known to forecast the single dependent value selected by the researcher. (Hair, 2006)

Data –

Annual financial statement data for 27 sugar mills of Pakistan listed on KSE is taken to calculate free cash flow and annual capital expenditure for the period 2000 through 2008.

Variable –

1. Independent variable = Free Cash Flow (FCF)

2. Dependent variable = Net Capital Expenditure

Independent variable:

The FCF is calculated they way Lehn and Poulsen (1989) and McLaughlin, Safieddine, and Vasudevan (1996) defined it. It is operating income before depreciation, less interest expense on debt, less income taxes, less preferred and common dividends.

Free cash flow = Operating income before depreciation – interest on debt – income taxes – preference & common stock dividend.

Dependent variable:

Net capital expenditures are those where funds are used to acquire or upgrade physical assets such as property, industrial buildings or equipment. Change in fixed assets over a year is taken as net capital expenditure by the firm.

Net capital expenditure = Current year fixed assets – last year fixed assets.

Net capital expenditure = Ln (FA)

Ln of fixed assets is taken to control the variability of the data.

Sampling criteria – Sample companies that are taken for the purpose of research are 27 sugar mills of Pakistan that are listed on Karachi Stock Exchange.

Hypothesis –

Free Cash flow has a significant relationship with capital expenditure.

Data analysis –

Annual financial statement data for 27 sugar mills of Pakistan, listed on Karachi Stock Exchange (KSE), was taken to calculate free cash flow and annual capital expenditure over the 2000-08 period.

Model Summary


R Square







Predictors = (Constant), FCF

Dependent Variable = Ln FA

The researcher has used statistical software SPSS 13.0 to process the data and run regression analysis on the variables. The results are interpreted in light of statistical text book by Hair (2006). All FCF and (ln) FA figures are in Million Rupees.

R value: It is the sample correlation coefficient between the outcomes and their predicted values, or in the case of simple linear regression, between the outcome and the values being used for prediction.

R – value of 0.302 means that the strength of the relationship between FCF and capital expenditure is 30.2%.

R squared value: the coefficient of determination, R2 is the amount of variance in the dependent variable that can be explained by the regression model.

The R square of 0.091 means that 9.1% of the variability in the data is explained by the predictor. Out of the total free cash flow, 9.1% is used for capital expenditure.

The F test for the regression model is significant which proves that regression model is best fit.

Regression model summary is showing that FCF has a positive impact on net capital expenditure.









Std. Error











Dependent Variable: Ln FA

Unstandardized Equation: Ln FA = 3.251 + 0.004 FCF

Standardized Equation: Ln FA = 0.302 FCF

If FCF changes by 1 million, ln of net capital expenditure changes by 0.004, which means Net Capital expenditure increases by 1.004008 million.

The regression coefficie

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