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.
The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash
flows, 2) how debt can substitute for dividends, 3) why “diversification” programs are more likely
to generate losses than takeovers or expansion in the same line of business or liquidationmotivated
takeovers, 4) why the factors generating takeover activity in such diverse activities as
broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to
perform abnormally well prior to takeover.
