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

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 concern

UNIVERSITY OF ECONOMICS ERASMUS UNVERSITY ROTTERDAM

HO CHI MINH CITY INSTITUTE OF SOCIAL STUDIES

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 INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM 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

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

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

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

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

LIST OF FIGURES

Figure 2 1: Summary of separate research related to capital structure, free cash flow, diversification and firm performance 30Figure 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

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

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

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

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

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

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

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 trade-off 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

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

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 low-risky 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

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

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

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

Invesment = maintain existing + Investment on + in

Expenditure assets in place New projects 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

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

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

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

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

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

diversification strategy because of the block from investors in order to protect firm value

In summary, the different results of previous studies may be due to the inspection of diversification discount separately, but is not associated with other factors

Rijamampianina et al (2003) studied a conceptual model or a process to improve firm performance through competitive advantage from diversification The authors said that related diversification (concentric diversification) brought more benefits to company than other types of diversification, but the competitive advantage of the company which came from diversification were also quickly being copied by the competitors and thereby loses its inherent advantages The authors pointed out that, to ensure the sustainability of competitive advantage, company need to build the barriers to prevent the imitations of the competitors, in particular, these barriers best promoted efficiency when they were built as soon as company began to diversify or capture potential benefits from diversification, meanwhile, the competitors could not catch up with or understand the source of competitive advantage In terms of the motivation of diversification, Rijamampianina et

al (2003) gave six reasons for why a company chooses diversifying:

(1) Increased stock value

(2) Increased Company’s growth rate

(3) Better use made of funds than internal investment

(4) Revenure growth

(5) Improved stability of income

(6) Increase efficiency and profitability

The authors pointed out that a successful diversification strategy, which had three of the following inheritance the strength from the core business, diversification into areas which close to the core business and improving the skills from the core business, helped company increase competitive advantage, thereby improving firm performance Finally, the authors offered a concepture model includes 4 steps to express the impact of diversification on performance Step 1: diverse resources to create competitive advantage

Step 2: the construction of the barriers to imitation created sustainable competitive advantage Step 3: the development in sustainable competitive advantage made the effective concentric diversification And finally, step 4: effective related diversification would improve fỉm performance Rijamampianina et al (2003) made these motivation comes from the level of firm performance It means that depending on high or low performing, company choose the diversify forms and degree of diversification Therefore, based on the aforementioned studies and theories of diversification motives, we can see that there are an endogenous relationship between diversification and firm performance Park and Jang (2013) by collecting and analyzing data from 308 restaurant companies gave the evidence that diversification is amplified by free cash flow Simultaneously, evidence also provides a conclusion that related diversification increase firm value and between related diversification and firm performance have a negative endogenous relationship

2.1.4 The relationship between diversification and capital structure

There are three theories about the relationship between the diversification and leverage: Co-insurance effect, transaction cost hypothesis and agency theory

The co-insurance effect said that cash flow volatility can be mitigated by the implementation of diversification, and minimize the difference of the cash flows will lead the company's debt increase In addition, the income from related diversification company correlated more strongly than the income stream from unrelated diversification company Then, co-insurance effect can explain the corporate debt leverage in related diversification firm will be smaller than in unrelated diversification firm Berger and Ofek (1995), Lawenllen (1971), Kim and McConnell (1977) found out the evidence to support the theory Berger and Ofek (1995) explored the relationship between diversification and firm value by comparing the total value of each segments of the diversified company to the actual value of this company The authors used data including 3,659 firms with 16,181 observations, of which 5,233 are multi-segment in the period of 1986-1991 from the Compustat Industry Segment (CIS) and Compustat The selected

companies were fully data during the studied period, with at least 20 million dollars in total sales and not had any segments in the financial services industry In addition, each segment of the diversified company must also ensure sales of at least 1% of the total sales

of the company The authors calculated the imputed value of each segment by multiplying the median ratio, for non-diversified compaies in the same industry, of total capital to one of three accounting items (assets, sales, or EBIT) by the segment’s level of the accounting item Then, the authors estimated the percentage difference between the company values and the total value of the segments in order to find evidence about the impact of diversification on corporate value Moreover, the authors also considered the impact of diversification on the company value by year and by size of company The empirical results indicated that diversification destroys firm value in all three estimation using the asset multiplier, the sale multiplier or using EBIT multiplier during the study period or any company size Explain to the loss of values, the authors suggested that there

were two main reasons First, the over investment could lead to a decline in the value of the company Second, cross-subsidization is also the cause of the loss of value in the

diversified companies The cross-subsidy is the strategy which the company would charge the higher price in this group of customers to offset to the lower price in another customer group The author conducted testing to find out the answer of the question whether the appearance of negative cash flow segments destroyed more value on diversified firm than the appearance of negative cash flow has on focused firm value The authors found that diversified firms with negative cash flow segments had significant lower values than diversified firms without negative cash flow segments However, the authors also found evidence that related diversification increased company when estimation company value by using the asset multiplier, the sale multiplier The author has used the co-insurance effect to explain this result Accordingly, the diversified companies could take advantage of more benefits from the tax shield than other companies by raising debt ratio At the same time, these compaies also took more advantage of tax benefits when using the loss in this segment to offset profits from other segments, thereby reducing the tax payable However, the authors also pointed out that

the benefits from the tax shield in the diversified companies with high debt ratio in capital structure were not large On the other hand, Majd and Myers (1987) also argued that the increase in debt through diversification can contribute to improving firm performance by gaining benefit from the tax shield The diversification firm with high debt leverage will take advance from the benefits of tax deductions than the other competitors which do not use or use less leverage

Transaction costs hypothesis of Markides and Williamson (1996) argued that a decision

on capital structure which the ratio of debt and equity is determined by the characteristics

of the company assets The hypothesis suggested that the specific assets should be financed by equity and vice versa non-specific assets should be financed by debt Accordingly, specific assets, related to related diversification should be financed by equity because they are limited in terms of liquidity, the difficulty of liquidation when the company went bankrupt In contrast, general property, involving unrelated diversification should be financed by debt as they are easily liquidated in the event of bankruptcy and also has the ability to use as collateral This leads to the conclusion that related diversification will reduce leverage while unrelated diversification will increase the leverage of the company

Finally, Jensen and Meckling (1976) have contributed to the debate on the relationship between leverage and diversification through agency theory As mentioned above, the debt can reduce power of managers in decisions investment by reducing free cash flow, thereby reducing the diversification strategy, especially unrelated diversification Therefore, the shareholders usually prefer to use debt as a tool to control the managers and prevent them harm to firm value through investments in unrelated industries Besides, Li and Li (1996) said that the diversification company with low debt leverage can lead to over – investment Therefore, the diversification companies need to maintain

a debt ratio higher than non – diversification companies to prevent over – investment Agency theory proposes that the increased leverage will reduce the unrelated

diversification; however, this relationship in the related diversification company is unclear

Amit and Livnat (1988) tested the inter – relationship between diversification, capital structure and risk by using path analysis The empirical results lead to the conclusion that companies by diversification will minimize risks but increased debt leverage to take advantage of the tax deductions Ruland and Zhou (2005) suggested that diversification damage to firm value but positive effect on firm value indirectly through increased financial leverage In their study, the authors questioned why financial leverage could impact on the diversification discount The authors used the data from Compustat to test the impact of leverage on firm value in the diversified companies The paper suggested the hypothesis that the leverage would increase the firm value in the diversified companies, but would not have impact on the companies which not diversification Based

on research of Berger and Ofek (1995), the authors developed empirical model with the dependent variable was the excess value and the independent variables were dummies diversification, total assets, earning before interest and tax, capital expenditures and the interaction term for diversification and leverage At the same time, the author also used a control variables as the percentage of shares outstanding held by top executives, interaction term between diversification and managerial ownership, common dividends divided by the market value of equity, net property plant and equipment, and cash from operating activities Data for the study were collected from the Compustat database After excluding the financial companies or companies had the financial segments, the final study sample included 48,773 firms-year observations which 11,831 observations from diversified firms in the period of 1990-2001 The authors estimated the annually cross-sectional regressions to reduce estimation errors attributable to inter-temporal correlation

of regression residuals across companies and one-way and two-way fixed effects models

to robust cross-sectional and temporal heterogeneity Finally, the authors used simultaneous equation regression Two Stage Least Squares (2SLS) to robust the endogenous problems between leverage variable and excess value variable The

experimental results indicated that diversification reduced the value of the companies; while leverage increased the value of the diversification companies but harmed the firm value of the specialized companies The author used the agency problem to explain these results Accordingly, these diversified companies with large positive free cash flow and have a lack of expected investment opportunities would tend to invest more in the projects which low effective than specialized companies High debt ratio will reduce free cash flow, thereby reducing the agency cost of companies Moreover, the authors also noted that, the leverage also helped to control cross-subsidization in the inefficient segments Park and Jang (2013) also concluded that unrelated diversification increases leverage but did not find evidence that related diversification effects on leverage In contrast, the authors found evidence that high debt leverage decrease related diversification

2.2 Summarize the previous studies about the relationship between the capital structure, free cash flow, diversification and firm performance

The relationships between firm performance, capital structure, free cash flow and diversification have been studied carefully However, these studies are considered those factors in isolation and independently There is a lack of research focused on the links between the four factors holistically and comprehensively

The relationship between capital structure and firm performance is explained through three main theories: trade – off theory, pecking – order theory and agency theory Tang and Jang (2007) with the trade – off theory argued that the company will set a target debt ratio in which the benefits from tax shield and costs of bankruptcy will be considered seriously The pecking – order theory of Majluf and Myers (1984) through the asymmetric information between investors and managers gave priority order for the funds

of the company: first the internal capital such as retained earnings, then by debt and the last one is from the new equity issued Finally, agency theory (Jensen and Meckling, 1976) suggested that leverage can be used as a tool to control the over - investment

activities of managers, thereby reducing the over financial excess, improve company performance

Free cash flow has significant impact on the diversification Berger and Ofek (1995) has documented that investors will want to invest in other industries to reduce free cash flow

in the company in case it is too much These investment and diversification strategies would negative impact on firm value, which called "diversification discount." There is much debate about the origin of the "diversification discount." While Doukas and Kan (2004) said that the implementation of diversification including related or unrelated are leading to the "diversification discount", Villalonga (2004) argued that only unrelated diversification decrease firm value, related diversification will increases the value of company In addition, according to Rijamampianina et al (2003), the firm performance also impact on a decision of diversification and degree of diversification

There are three theories about the relationship between diversification and capital structure: the co – insurance effects, transaction cost theory and agency theory According to the co – insurance effects (Berger and Ofek, 1995), the implementation of diversification is a reasonable manner to increase debt leverage, which will reduce the volatility of cash flow Transaction cost theory (Markides and Williamson, 1996) suggested that the characteristics of the assets are the most important factor that should be considered before the capital structure decisions Finally, agency theory (Jensen and Meckling, 1976) also contributed to the debate on the relationship between diversification and capital structure when suggested that the increase in debt leverage could reduce the level of investment of managers in related and unrelated diversification projects, reduce risks for investors and limited the power of managers

Amit and Livnat (1988) tested the relationship between diversification and capital structure and systemic risk using path analysis Research has found that companies minimize their risks through the implementation of diversification, but at the same time increased leverage for the tax deductions benefit However, the study could not provide details about the relationship of each diversification strategies to the firm Park and Jang

(2013) has collected data from 308 restaurant companies and using a holistic analysis to identify the relationship between the four factors firm performance, capital structure, free cash flow and firm diversification The authors have found evidence suggesting that the diversification discounts in diversified companies are not derived from the free cash flow but have negative effect on firm performance The paper also supports the free cash flow hypothesis when argued that a large free cash flow increases investment in both related and unrelated diversification The balance of debt helps to reduce free cash flow, and enhance firm value

Table 2 1: Summary the previous theories and studies

1 Tang, C.,

Jang, S.,

2007

Straightforward ordinary least squares (OLS) regression and

Generalized least squares analysis

27 loging firms and

27 sofware firms in the period of 1997-

2003 from Compustat database

In loging firms, fixed assets, growth opportunities, and the inter-relationship between these two variables had positive significant effect on firm’s long-term debt behavior

851 firms in 25 industries from

1962 to 1981 from Annual Compustat

Optimal leverage of the companies had a negative relationship with the expected cost of the financial distress, and non-debt tax benefits At the same time, the optimal financial leverage also inversely related to companies income if considering the cost of the financial distress

3 Rajan, R.,

Zingales,

L., 1995

Maximum likelihood and a censored Tobit model

4,557 non-financial firms from G-7 countries in the period of 1987-

1991

These factors impact on the capital structure decisions among the G-7 countries were similar Tangible assets and firm size had a positive impact

on leverage Conversely, Market to book and profitability

had a negative relationship with leverage

4 Myers, S.,

Majluf,

N., 1984

Qualitative estimates

- Companies should finance investment by retained earnings, then debt and finally the new equity

- If the investment required exceeded the ability of cash and low-risk debt, companies should ignore investment projects rather than issuing new equity

- Companies can accumulate cash by reducing dividends

- Companies should not pay a dividend if it is used to replace the cash without raising external capital

- If the managers hold superior information, the stock price would fall when they are released to finance investment

- The consolidation of companies with low and high cash holdings would increase the company’s combined value

5 Ross, S.,

1977

Qualitative estimates

- The company with high debt levels will emit a signal to investors that the future cash flows of the company are high quality If a company is

required to issue new equity, that would be a negative signal

- Odinary least squares (OLS)

- Cross-sectional sample: 1014 exchange listed non-financial firms from 18 emering markets in 1995-

1996

- Time-series sample: 547 exchange listed

- Debt lessened the reduction

in firm value that follow a separation between a management group’s control rights and its proportional cash flow ownership

- The international loans earn positive cumulative aberrant returns These cumulative aberrant returns are positive

non-financial firms from 20 emering markets in the period of 1980-

1997

- Ownership issuing sample: 252 firms

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 are not matched with management ownership structures

7 Richardso

n, S.,

2006

Pooled regression with Huber-White standard errors

- The sample of 58,053 firm-year observations during the period

- Certain governance structures can reduce over-investment

- The sample of

1570 firm-year observations during the period

- The impact of the different types of strong governace on sales growth and firm

of Fama and Macbet (1973)

The sample of 237,673 firm-year observations during the period of 1950-

2003

Data collection from Compustat and Center for Research in Security Prices

- The higher constant of the cash was distributed by cash from equity

- Stock prices act as if investors anticipate the constant of

earnings from debt and equity, but overestimate the constant of earnings that is retained cash balance

- If the companies had a large positive free cash flow, they would spend almost of it to future investment projects which gained the lower marginal benefit and therefore, would reduce the value of the

- Compustat data:

45,998 year observations of 29,577 firm-year in 1989-1996

segment BITS data:

50,708,528 establishment-year observations of 41,203,605 firm-year in 1989-1996

Unrelated diversification gave company a discount but related diversification brought to company a premium

- Related diversification brought more benefits to company than other types of diversification

- Company need to create the barriers to imitation by competitors to ensure the sustainability of competitive advantage

- There were six reasons why companies choose to diversify

- There were four steps to improve the firm performance through efficient related diversification

12 Berger,

P., Ofek,

E., 1995

Multivariate regressions

- A sample of 3,659 firms with 16,181

observations, of which 5,233 are multi-segment in the period of 1986-

1991 which collected in The Compustat Industry Segment and

Compustat

- The choosen firms have at least

$20 million and have no segments in

- The diversification destroyed the firm value in all time and any size of firm which can be explain by over-investment and cross-subsidization

- A positive significant effect of related diversification on firm value has found out which can

be explain by the co-insurance effect

Cross One – way fixed effect

- Two – way fixed effect

- Two – stage least squares

A sample of 48,773 firms-year

observations which 11,831 observations from diversified firms in the period

of 1990-2001 in Compustat data base

- Diversification destroyed the firm value

- Leverage reduced the value in the non-diversification

companies but had the positive effect on value of diversified companies

14 Park, K.,

Jang, S.,

2013

- Two – stage least squares

- Three – stage least squares

A sample of 308 restaurant

companies in the period of 1995-

2008 which total

2829 firm-year observations

- Leverage has the positive effect on firm performance, but firm performance has no impact

on leverage directly It negative effect on unrelated

diversification which positive effect on leverage

- The free cash flow increase diversification in both two types And it derectly destroyed firm performance A negative effect of leverage on free cash flow was also found

- Related diversification had a positive effect on firm

performance, but the relationship between unrelated diversification and firm

performance is negative Debt leverage can decrease the related diversification and unrelated diversification has positive effected on leverage

2.3 A holistic framework

(a) Capital structure and firm performance

(b) Free cash flow hypothesis in the relationship between leverage and firm

performance

(c) Diversification discount and free cash flow

Tax shield and cost of bankruptcy

Diver- sification

Perfor- mance

Agency cost

Managers compensation

Initial investment

FCF

Prevent over - investment

Financial excess

(d) Leverage and diversification

Fingure 2 1: Summary of separate research related to capital structure, free cash

flow, diversification and firm performance

Figure 2 1: Holistic framework for capital structure, free cash flow, diversification

and firm performance

Diversification

Perfomance Leverage

Free cash flow

Capital flow volatility

Asset characteristics Agency cost

CHAPTER 3: METHODOLOGY 3.1 Model

The study adopted the model of the Park and Jang (2013) to clarify the relationship between the four factors: capital structure, free cash flow, firm diversification and firm performance The dependent variables are used in the research are Tobin’s q (representing firm performance), FCF (representing free cash flow), R_entropy (related diversification), U_entropy (unrelated diversification) and finally ln(TDL) (representing the company's capital structure) The empirical models are used to test the inter – relationships between the four factors are as follows:

ln(Tobin’s q) i,t = α + β 1 x FCF i,t + β 2 x R_entropy i,t + β 3 x U_entropy i,t + β 4 x ln(TDL) i,t +

β 5 x Cashflow i,t + β 6 x Sales_GR i,t + β 7 x ln(sales) i,t + ∑DY t + ε i,t (1)

FCF i,t = α + β 1 x ln(TDL) i,t + β 2 x equity_repurchase i,t + β 3 x dummy_Dividend i,t +

R_entropy i,t = α + β 1 x FCF i,t + β 2 x ln(Tobin’s q) i,t + β 3 x ln(TDL) i,t + β 4 x RER i,t + β 5 x

PPNE i,t + β 6 x ln(Ad_Ex) i,t + β 7 x ln(sales) i,t + ∑DY t + ε i,t (3) U_entropy i,t = α + β 1 x FCF i,t + β 2 x ln(Tobin’s q) i,t + β 3 x ln(TDL) i,t + β 4 x RER i,t + β 5 x

ln(TDL) i,t = α + β 1 x R_entropy i,t + β 2 x U_entropy i,t + β 3 x ln(Tobin’s q) i,t + β 4 x QR i,t

+ β 5 x Wcap i,t + β 6 x ln(Capx) i,t + β 7 x ln(sales) i,t + ∑DY t + ε i,t (5)