The Role of Enterprise Risk in the Relation between the CEO's Skills and the Firm's Free Cash Flow

Abstract

This study examines the role of Enterprise Risk (ER) in the relation between the CEO's skills, including financial knowledge and his power, and the Free Cash Flow (FCF). If the CEO is a member of the board of directors, it shows his power. A sample of 102 companies during 2014 to 2020 was selected from the firms listed on the Tehran Stock Exchange (TSE). The screening method was used for sampling and the tests ran by using multiple regression based on the panel data model with fixed effects. The results showed that there was an insignificant relation between CEO's power and FCF, but ER moderated the relation between CEO's power and FCF positively and significantly. Therefore, just having dual duties and being a member of the board of directors had no effects on FCF. Hence, in the context of increasing ER, there was a positive relation between CEO's power and FCF. There was no significant relation between financial knowledge and ER with FCF, while ER negatively and significantly moderated the relation between CEO's financial knowledge and FCF. Therefore, ER increased the impact of the CEO's power and weakened the effect of the CEO's financial knowledge and with the presence of the ER, the CEO's power was more effective in the firm's FCF compared his financial knowledge.Keywords: CEO's Power, CEO's Financial Knowledge, Enterprise Risk, Free Cash Flow (FCF). IntroductionA good firm's performance leads to the creation of cash inflow and proper cash management provides a basis for the company's future profits. Risk management through risk reduction provides the basis for achieving the organization's strategic goals, such as efficient investment and optimal use of cash flows (Kokobe & Gemechu, 2016). The contribution of this study is whether enterprise risk affects the relationship between the CEO's skills and the free cash flow. Managers with dual roles have more power than other stakeholders, thus their ability to earn higher rents is evident. CEOs use their power to determine the company's payment policies to serve their interests, thus they retain more excess cash (Tian, & Yang, 2014). Enterprise risk management increases the value of the company and therefore can reduce the negative net cash flow or increase the net cash flow (Tahir and Razali, 2011). Custodio and Metzger (2014) found that companies that hired CEOs with financial knowledge retained less cash and less free cash flow. Matsunaga, Wang, & Yeung (2013) showed that Companies with more cash outflows are facing a shortage of cash, and published conservative reports. Method and DataTo test the research hypotheses, 102 companies were selected from the companies listed on the Tehran Stock Exchange (TSE) during the years 2014-2020. Based on Chow and Hausman’s tests, the panel data model with fixed effects is suitable for all research models. In this study, the panel regression models with Generalized Least Squares (GLS) were used. FindingsThe results showed that the CEO's power, financial knowledge, and Enterprise Risk (ER) have no significant relations with the firm's FCF. ER positively and significantly moderated the relation between the CEO's power and the firm's FCF. ER negatively and significantly moderated the relation between the financial knowledge of CEOs and the firm's FCF. According to the results of the 4th and 5th hypotheses, ER had an effective role in the relation between the power and financial knowledge of CEOs and the firm's FCF. Conclusion and discussion Managers use their power to advance their own personal goals and motivations. In this study, no direct relation between Enterprise Risk (ER) and Free Cash Flow (FCF) was found because the cash from sales was used for different purposes and programs and the mediating variables could be effective in this relation. Managers' opportunistic motives to secure their own personal interests increase the firm's risk. In this situation, they have a great incentive to increase FCF. With the presence of the ER, powerful managers maintain more FCF. Therefore, ER weakens the relation between the financial knowledge of the CEO and the firm's FCF. ER reduces the CEOs' power so that they cannot use their knowledge to achieve enterprise goals. On the other hand, to reduce the effect of risks facing the company, they keep more surplus cash. Managers with a dual role in Iran are often representatives of the majority-owned stockholders, who act in the interests of their respective stockholders. According to the research findings, ER and CEOs' power and financial knowledge were the factors affecting the FCF. Paying attention to the managers’ professional characteristics and environmental conditions, including ER created favorable corporate governance, decreased information asymmetry, reduced the risk of inefficiency, alleviated the managers’ opportunistic behaviors, and enhanced investment efficiency or lowered inefficiency. Therefore, the participants in the Iranian economic markets should pay attention to managers’ characteristics and organizational risks, as well as the strategies of companies for managing FCFs.

Keywords

• ceo's power
• ceo's financial knowledge
• enterprise risk
• free cash flow (fcf)