Due Diligence

“The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows—more cash than profitable investment opportunities.” – Michael Jensen – “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers”

This work profoundly shifted our understanding of corporate finance and governance by introducing the concept of free cash flow as a double-edged sword: a sign of a firm’s potential strength, but also a source of internal conflict and inefficiency.

Jensen’s insight was to frame the relationship between corporate management (agents) and shareholders (principals) as inherently conflicted, especially when firms generate substantial cash beyond what they can profitably reinvest. In such cases, managers — acting in their own interests — may prefer to expand the firm’s size, prestige, or personal security rather than return excess funds to shareholders. This can lead to overinvestment, value-destroying acquisitions, and inefficiencies that reduce shareholder wealth.

Jensen argued that these “agency costs” become most acute when a company holds large free cash flows with limited attractive investment opportunities. Understanding and controlling the use of this surplus cash is, therefore, central to corporate governance, capital structure decisions, and the market for corporate control. He further advanced that mechanisms such as debt financing, share buybacks, and vigilant board oversight were required to align managerial behaviour with shareholder interests and mitigate these costs.

Michael C. Jensen – Biography and Authority

Michael C. Jensen (born 1939) is an American economist whose work has reshaped the fields of corporate finance, organisational theory, and governance. He is renowned for co-founding agency theory, which examines conflicts between owners and managers, and for developing the “free cash flow hypothesis,” now a core part of the strategic finance playbook.

Jensen’s academic career spanned appointments at leading institutions, including Harvard Business School. His early collaboration with William Meckling produced the foundational 1976 paper “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”, formalising the costs incurred when managers’ interests diverge from those of owners. Subsequent works, especially his 1986 American Economic Review piece on free cash flow, have defined how both scholars and practitioners think about the discipline of management, boardroom priorities, dividend policy, and the rationale behind leveraged buyouts and takeovers.

Jensen’s framework links the language of finance with the realities of human behaviour inside organisations, providing both a diagnostic for governance failures and a toolkit for effective capital allocation. His ideas remain integral to the world’s leading advisory, investment, and academic institutions.

Related Leading Theorists and Intellectual Development

• William H. Meckling
  Jensen’s chief collaborator and co-author of the seminal agency theory paper, Meckling’s work with Jensen laid the groundwork for understanding how ownership structure, debt, and managerial incentives interact. Agency theory provided the language and logic that underpins Jensen’s later work on free cash flow.

• Eugene F. Fama
  Fama, a key contributor to efficient market theory and empirical corporate finance, worked closely with Jensen to explain how markets and boards provide checks on managerial behaviour. Their joint work on the role of boards and the market for corporate control complements the agency cost framework.

• Michael C. Jensen, William Meckling, and Agency Theory
  Together, they established the core problems of principal-agent relationships — questions fundamental not just in corporate finance, but across fields concerned with incentives and contracting. Their insights drive the modern emphasis on structuring executive compensation, dividend policy, and corporate governance to counteract managerial self-interest.

• Richard Roll and Henry G. Manne
  These theorists expanded on the market for corporate control, examining how takeovers and shareholder activism can serve as market-based remedies for agency costs and inefficient cash deployment.

Strategic Impact

These theoretical advances created the intellectual foundation for practical innovations such as leveraged buyouts, more activist board involvement, value-based management, and the design of performance-related pay. Today, the discipline around free cash flow is central to effective capital allocation, risk management, and the broader field of corporate strategy — and remains immediately relevant in an environment where deployment of capital is a defining test of leadership and organisation value.