Article - Jensen (Topic 2)

Question 1

What does Jensen discuss?

Answer 1

that FCF after dividends should be zero because any residual should optimally be distributed to shareholders

Question 2

How is FCF calculated?

Answer 2

FCF = TCF from Operating Activities – Capital Expenditures

TCF = Net income + depreciation added back

Question 3

What is the risk if FCF is retained within the firm instead of distributed?

Answer 3

that self-interested managers will invest in negative-NPV projects

Question 4

According to Jensen what do shareholders prefer?

Answer 4

to receive all FCF paid out in dividends

Question 5

How does Jensen suggest that agency problem can be deterred?

Answer 5

make sure the firm issued debt (and not equity) beforehand to force managers to pay interest on debt, which is mandatory (else, bankruptcy)
In contrast, dividends are optional

Question 6

what are two examples where debt could have been used as a discipline function?

Answer 6

Ford motors - purchasing Jaguar, FCF should not have been used to make this neg NPV investment
Oil industry - surplus FCF due to oil shortage, should have been paid out to shareholders instead of invested in neg NPV