In classical corporate finance, a firm should accept any project whose expected return exceeds its cost of capital and reject any project that falls short, returning surplus funds to shareholders, who can redeploy them. This prescription assumes that managers act as faithful agents of shareholders. The free-cash-flow theory of agency costs questions that assumption.

The theory begins from the observation that managers derive private benefits — prestige, compensation, and power — that scale with the size of the firm they control rather than with its profitability. A manager who returns surplus cash to shareholders shrinks the asset base under his command; a manager who invests that cash, even in a project earning less than the cost of capital, enlarges it. The theory predicts that managers of firms generating cash in excess of what their positive-return projects can absorb will be tempted to invest the surplus in such value-destroying projects rather than disgorge it.

Crucially, the theory does not claim that all firms with surplus cash will overinvest. It claims that the temptation is greatest, and the discipline weakest, precisely where surplus cash is abundant and where the mechanisms that ordinarily constrain managers — the threat of takeover, the scrutiny of creditors, the need to raise external financing — are slack. A firm flush with internal cash need not approach external capital markets, and so escapes the scrutiny those markets impose. From this, the theory draws a counterintuitive prescription: a firm can sometimes increase its value by taking on debt, not because it needs the money, but because the obligation to make fixed interest payments removes cash from managerial discretion and recreates the external discipline that abundant internal cash had allowed the firm to evade.

Empirical work has found that announcements of large debt-for-equity exchanges by cash-rich firms in mature industries tend to be met with increases in share price — a pattern difficult to reconcile with the classical view that debt is merely a financing choice of no consequence to firm value when capital markets are efficient.