Finance · level 3
Free cash flow agency cost
Put a number on empire building: capital invested below the cost of capital destroys its spread-to-WACC ratio in value. Knowing the size makes the governance fix (payout, debt, board control) concrete.
Worked example: A cash-rich firm reinvests all $700M of annual free cash flow for 5 years in acquisitions earning 6% against a 10% cost of capital. Roughly how much value does that destroy (perpetuity approximation)?
Step by step
- 1
Capital misallocated
$700M × 5 = $3.5B
- 2
Value gap per dollar
(ROIC − WACC) / WACC = (6% − 10%) / 10% = −40%
- 3
Value destroyed
$3.5B × 40% = $1.4B
- 4
Jensen's free cash flow theory
Cash beyond positive-NPV needs tempts managers to grow the empire. Debt service and payouts are the bonding devices that remove the temptation.
A cash-rich firm reinvests all $700M of annual free cash flow for 5 years in acquisitions earning 6% against a 10% cost of capital. Roughly how much value does that destroy (perpetuity approximation)? = 1,400,000,000
The theory behind it
Intuition
Finance is time and risk applied to cash: move every cash flow to the same date at a rate that reflects its risk, then compare.
Common pitfalls
- ×Discounting a nominal flow at a real rate (or vice versa).
- ×Mixing enterprise-value and equity-value numbers in the same ratio.
In the interview
Valuation, WACC, LBO and accretion rounds — where a wrong bridge is a wrong answer.