Free Cash Flow, Agency Costs, and the Affordability Method of Advertising Budgeting

Abstract

The allocation of excess cash has long been recognized in the finance literature as an important aspect of the basic agency conflict between managers and owners. In the advertising budgeting context, marketing scholars report that firms possessing high levels of cash tend to spend more on advertising than what seems necessary or desirable. Indeed, this positive link between excess cash and advertising expenditures constitutes a part of what is commonly referred to as the affordability method of advertising budgeting. Surprisingly, there has been little research that attempts to view this association as a manifestation of agency costs. Therefore, in this article, the authors examine whether agency costs, as measured by managerial ownership, moderate the relationship between excess cash and advertising expenditures. On the basis of received theory, the authors conceptualize that agency costs will first decrease, then increase, and then decrease again with the level of managerial ownership. Accordingly, the authors hypothesize and find that the fraction of incremental earnings reinvested in advertising follows the same pattern in managerial ownership. These findings support the notion that the use of the affordability method is driven, in part, by agency costs. The authors conclude by discussing the theoretical and managerial implications of the findings.

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