THE RELATIONSHIP BETWEEN FIRMS' FREE CASH FLOW AND INVESTMENT: AN EMPIRICAL STUDY ON MALAYSIAN PUBLIC
LISTED COMPANIES
WeraLukam
HF 5681 C28 W484
Corporate Master in Business Administration 2011
2011
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P.KHIDMAT MAKLUMAT AKADEMIK
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THE RELATIONSHIP BETWEEN FIRMS' FREE CASH FLOW AND INVESTMENT: AN EMPIRICAL STUDY ON
MALA YSIAN PUBLIC LISTED COMPANIES
WERALUKAM
A dissertation submitted in partial fulfillment of the requirements for the degree of Corporate Master in Business Administration
Faculty of Economics and Business UNIVERSITI MALAYSIA SARA W AK
2011
DEDICATION
To my wife, Mascy and my two daughters, Dorothy and Fiona
Who always steadfastly giving support and confidence
Who has together persevere through the time
Throughout the period ofmy
Pursuing this course
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ACKNOWLEDGEMENT
I wish to express my sincere thanks to University Malaysia Sarawak (UNIMAS), All staffs of
the Faculty of Economy and Business, the Dean of FEB, the Coordinator of CMBA and my
thesis supervisor, Dr. Chu Ei Yet for all the invaluable knowLedge, guidance and assistance
rendered to me throughout the entire course duration of my pursuing this CMBA course.
Thank you.
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ABSTRACT
( ThiS study examines the relationship between firms' investment, as dependent variable, and
the respective free cash flow, as the independent variable. The study on the relationship has
also been extended further to include other independent variables such as firms' debt ratio,
size (a measure of the total asset value), dividend payout, agency problem, Tobin's Q (a
measure of the share market value) and cash account uses. The sample used comprises of 110
non-financial companies listed on the Bursa MalaYSia) It was found that there is a
significantly negative relationship between firms' investment and the respective free cash
flow. Also, higher partially significant relationship has been found between firms' investment
and dividend payout and debt ratio negatively and positively with Tobin's Q. While lower
partially significant relationship was found between firms' investment and frrms' size and
cash account uses negatively and positively with agency problem.
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ABSTRAK
Kaj ian ini adalah untuk memerhati hubungan diantara tahap nilai perlaburan dan aliran tunai
bebas syarikat. Kajian juga telah di panjangkan kepada hubungan diantara pelaburan syarikat
dengan faktor-faktor seperti kadar nilai hutang, keseluruhan nilai aset, nilai dividen dibayar,
masaalah antara pengurusan dan pemegang saham, nilai pasaran saham dan nilai penggunaan
tunaL Contoh syarikat yang digunakan dalam kajian ini terdiri daripada 110 buah syarikat
bukan kewangan yang sedang disenaraikan di Bursa Malaysia. Hasil kajian mendapati
bahawa satu hubungan songsang yang nyata telah diperolehi diantara pelaburan syarikat
dengan aliran tunai bebas. Didapati juga hubungan nyata yang tidak sepenuhnya pada tahap
yang tinggi diantara pelaburan syarikat dengan pembayarall dividen secara songsang dan
secara terus dengan nilai pasaran saham. Sementara itu, hubungan nyata yang tidak
sepenuhnya pada tahap rendah telah dipamerkan bagi hubungan diantara pelaburan syarikat
dengan nilai jumlah syarikat dan penggunaan tunai secara songsang dan dengan masaalah
antara pengurusan dan pemegang saham syarikat secara terus.
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Pusat Khidmat MakJum (Ak dtm. , UNIVERSm MALAYS1A SARAWAJ(
Table of Contents
Chapter Page
DEDICATION
ACKNOWLEDGEMENT ii
ABSTRACT ii i
ABSTRAK iv
1.0 INTRODUCTION
1.1 Background
1.2 Problem Statement 4
1.3 Objectives 7
1.4 Scope of study 10
1.5 Significance of study 11
1.6 Limitations 12
1.7 Conclusion 12
2.0 LITERATURE REVIEW
2.1 Introduction 13
2.2 Literature Review 13
2.2.1 Investment and Free Cash flow 14
2.2.2 Accessibility to External Capital 15
) 2.2.3 Firm Size 16
2.2.4 Dividend Payout 17
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2.2.5 Agency Problem 18
2.2.6 Tobin's Q 19
2.2.7 Cash Account Uses 19
2.2.8 Regional Disparities, Sales Growth and
Financial Derivatives 20
2.3 Conceptual Framework 21
2.4 Theoretical Framework 22
2.5 Conclusion 23
3.0 METHODOLOGY
3.1 Introduction 24
3.2 Measurement of Variables 24
3.3 Data Sampling and Collections 24
3.4 Hypotheses 25
3.5 Empirical Model and Data Analysis 27
3.6 Conclusion 30
4.0 RESULTS
4.1 Introduction 31
4.2 Sample Variables Statistics 31
4.3 Investment and the Influencing Variables 33 [ ) 4.4 Conclusion 40
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5.0
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INFERENCES AND CONCLUSION
5.1 Introduction 41
5.2 Inference ofResults 41
5.3 Implication of Government Policy and Other
Influencing Factors 44
5.4 Conclusion 45
LIST OF REFERENCES 46
LIST OF APPENDICES 49
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List of Figures and Tables Page
Figure 1.1 Total Nominal Investment and Manufacturing Sector
Capacity Utilisation 5
Table 3.1 Measurements of Variables 29
Table 4.1 Sample Variables Statistics 34
Table 4.2 Results of Regression 36
Table 4.3 Results of Regression with weighted un-standardized
residual 37
Table 5.1 Summary results of hypotheses 42
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CHAPTER 1 - INTJ.{ODUCTION
1.1 Background
The main objective of most firms is that of increasing shareholders' wealth. Managers and
Chief Executive Officers are therefore vested with this responsibility in their respective firms.
Increasing shareholders' wealth can come in a number of ways, such as increasing firms'
profitability as well as capital appreciation. It is therefore imperative that firms continue to
improve its financia) performance going forward. Public listed firms were very often seen to
announce the improved financial performances, which could subsequently improved the
firms' market value and in turn increase shareholders' wealth.
One of the most common means by which firms could increase profitability is by engaging in
new investment on positive net present value (NPV) projects. Investment, in this context,
referred to as the acquisition of new additional assets for use in firm's profitable business
operation. Possession of strategic assets is also a necessary condition for firms to sustain
competitive advantage (Kochhar, 1997). In pursuing further profitable investment activities,
firms would be facing the decisions to source for finance needed for investment. The ability
for firm to use its own cash flow as a source of investment funding would be readily preferred
by firms. However, that would be very much depended on the firm capacity to provide the
necessary funding from within.
Firms that do not have the capacity to provide sufficient internal fund for investment would
experience financial constraint. Firms facing financial constraint would resort to sourcing
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from other sources of financing in order to embark on positive NPV investment opportunities
such as issuing new shares or sourcing from borrowings. When referring to finns' own
internal source of fund, finns' cash liquidity shall be taken as the more accurate representation
of its financial capacity. Being profitable, however, does not necessarily means being liquid,
since finn can be short of cash even though it is profitable. Thus, finns' financial capacity is
very much dependent on its available cash flow.
Cash flow is defined as the movement of cash into and out of a business. It equals cash
generated from operations after taxation and interest paid, plus all noncash deductions from
income and extraordinary items, minus dividends (Mundaca and Gabriela, 2008). On a more
specific context, free cash flow (FCF) measures how much cash that a business is able to
generate after laying out the fund required to maintain or expand its assets base. FCF is
defined as the cash flow in excess of that needed to fund all positive NPV projects when
discounted at relevant cost of capital (Jensen, 1986). FCF can be obtained from the finn's
statement of cash flow - calculated from the net cash flow from operation minus the capital
expenditure. FCF allows finn to pursue investment opportunities that would eventually
enhance shareholders' value. It would be difficult to develop new products, make
acquisitions, pay dividend and reduce debts without having sufficient cash at hand.
The main focus of this study is to establish a relationship between investment and free cash
flow on finns listed on the Bursa Malaysia. The objective is to conduct an empirical study
treating finns' investment as the dependent variable while free cash flow treated as the
independent variable. This study was conducted on a sample of 110 publicly listed, non
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finance firms over a period of 5 years for 2005 to 2009. A regression model was used where
Investment (lnv) shall be equated as the function of Free Cash Flow (FCF).
The interpretation of the relationship between cash flow and investment is controversial.
Some argue that it is caused by financial constraints, while, there are others who viewed that
the relationship had not been properly measured by Tobin's Q (Carpenter and Guariglia,
2008). Tobin' s Q ratio is the measure of firms' market value. It is a calculation of the market
value ofa finn divided by the value ofthe finn's total assets (Tobin, 1969).
Another way of presenting the relationship between investment and cash flow in finns is by
classifying into groups of high, low and negative sensitivity. The various levels. of these
sensitivity measures the significant of relationship between the variables. The findings had
uncovered that investment and cash flow sensitivity was ever-changing with respect to
financial constraints, cash flows and growth opportunities (Hovakiminian and Gayane, 2009).
Yet another factor which also influences this relationship is the agency problem. Agency
problem developed due to separation of ownership and control and thereby create conflict
between managers of the finns and the shareholders. In some cases, agency problem escalated
to the extent that managers made decisions that are contradict to its original objective of
increasing shareholders' wealth. Managers offinns are seen to invest fund on non-high return
or even zero return projects when free cash flow was positive and especially when firm is
under threat of takeover (Oprea, 2008). Due to the agency problem, managers are reluctant to
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pay dividend to shareholders but instead would channel the fund to investment regardless of
the profitability of the investment.
Apart from the above, there were also other factors which may have some influence on the
relationship between investment and free cash flow being considered in this study such as
finn size, dividend payout, accessibility to external fund and current account uses. In the
subsequent section, the various literature reviews specify the outcome of research findings
done with regards to the relationship between Investment and Free cash flow. The findings
were based mostly on the empirical studies conducted on foreign listed firms. However,
infonnation pertaining to similar study conducted on the Malaysian publicly ljsted firms is
presently not available.
1.2 Problem Statement
This study is to determine empirically the relationship between Free Cash Flow and the
investment activities on Malaysian Public Listed Companies. Firms normally continue to
invest into profitable investment opportunities in order to harness more profits and
subsequently improve firms' financial performances. This is indeed what firms' main
objective is. It is also in line with firms' expansion and diversification processes. In their
effort to continue investing, firms would be facing the decision of sources to obtain funds for
investment purposes. It is therefore quite obvious that firms' own cash flow would be the
priority source of fund for further investment.
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Pusat Khidmat M kJumat Akademik {lNIVERSm MALAYSIA AnA ...
Figure 1.1 depicts the total nominal investment and manufacturing sector capacity utilisation
over the period of 2004 to 2008, which was taken from the excerpt ofthe Bank Negara Report
2008 as shown in Appendix 'A'. The country's total nominal investment and manufacturing
sectors capacity utilisation had shown a rather steady level of percentage change which ranges
from about 3% to 20% for period between 2005 to 2007. However, following the sharp global
economic downturn in 2008, the country's private investment had drastically declined by the
later part of 2008. Demand for manufactured exports had declined during this period which
ultimately caused production activities to decline as well. Under such circumstances,
manufacturing sector had been severely affected and had caused the declined in the further
expansion exercise or investment activities. The global economic downturn had caused the
manufacturing sector to cut back on production which in turn caused reduction in cash flow
generated. The other sectors, however, had shown increased in the investment activities. The
mining sector and services sector had been seen to have perfonned quite well with improved
financial results. These sectors were seen to have embarked on further investment activities.
Figure 1.1 Total Norn,lnal InvestO'1ent and Manufacturing S ector Capacity Utilisation
en 0'"
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0 2030 4 Q ~o 20 3 Q 4Q'0 2 030 4 0 1 0 2 030 4Q
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2004 2:DOS 2006 2007 2 008
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The report stated earlier had indicated that there is a strong relationship between the finns'
cash flow availability to the investment activities. There were factors such as the global
economic downturn that had caused the finns to reduce the investment activities. The decline
in the investment, however, could be due to the decline in the demand of products which in
tum caused the reduction of available cash flow. In this study, the relationship between the
variables were investigate to cover the period of nonnal as well as under global economic
crisis. The effect of the various periods of economic environment towards the relationship of
investment and cash flow availability can be seen from the results ofthis study.
The Malaysian government had given out stimulus packages for 2008 and 2009 amounting to
RM7b and RM60b respectively (REHDA,2008) and (MIT,MIA & CPA, 2009) . These
stimulus packages had provided a portion of the allocated amount to promote investments in
the country by offering capital accessibility and profitable investment opportunities for finns.
Despite having these stimulus packages, the actual amount of investments, as specified in the
report above, had actually reduced during the respective period. This could mean that even
with available leverage and profitable investment opportunities do not guarantee for an
increased in investment activities. This would only enhance the significance of finns to
depend mainly from the free cash flow to embark on the investment activities.
Negative free cash flow would put finns in a situation of financial constraint and would
therefore reduce finns' capacity to invest. However, finns have other sources of funds for the
purpose of investment such as from borrowings as well as issuing new shares and derivatives.
The list is indeed non exhaustive. Therefore, how significant does finns' source of fund for
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investment come from its own cash flow remained unknown. As it is for now, there are
limited information pertaining to this relationship especially in the context of Malaysian
public listed firms, and even more so when considering the latest frrms' financial
performances. As such, the findings of this study would provide additional information
towards the knowledge in this area.
1.3 Objectives
(a) General
This study would provide an insight into the information on the relationship between the
Malaysian Public Listed firms' investment activities with the respective free cash flow. There
have been many studies done on this subject. However, all were on foreign countries' publicly
listed firms. Therefore, by conducting this study, the findings would offer additional
information for statistical use or for further research use in the same area.
(b) Specific
An empirical test shall be conducted on firms listed on Bursa Malaysia for the period of 2005
to 2009, to establish the relationship between the following variables on firm's investment
activities.
(i) Free cash flow
Free cash flow is the available cash flow after considering the capital expenditures.
Higher free cash flow is due to better financial performance. Good financial
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perfonnance allows the finn to be able to expand by embarking on further
investment activities. It is therefore intended in this study to establish the
significance of relationship between the investment activities and the finns' free
cash flow.
(ii) Accessibility of external capital market
Accessibility of external capital market allows the finns to make use of the capital
market to embark on investment activities on the available investment
opportunities. The government had offered incentives and stimulus packages to
finns in the fonn of ease of access to capital market as well as more investment
opportunities for finns. This study would be able to establish the capacity of finns
in harnessing the various incentives for investment purposes. The capital is usually
channelled to the finns through debt and equity markets.
(iii) Total assets value, a measure offinns' size
Improving finn's size, being measured on total asset value, could be an important
goal for finns to embark on investment activities. When finns invest on capital
assets, the finns' size would expand. The expansion would provide the finns with
better edge in competing in the market which ultimately improved the financial
perfonnance. This study would be able to establish how significant the effect of
finn size on the finn's investment activities.
(iv) Amount ofdividend payout
Dividend payout is part of available cash flow from finns' profit which was
disbursed to shareholders. This payment is therefore considered as rival to finns'
investment activities. Therefore, dividend payout would be expected to have
negative relationship with finns' investment-cash flow relationship in this study.
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(v) Tobin's Q as defined by Chung and Pruitt (1994)
Tobin's Q of the firms represents the market value or capitalisation. Normally,
higher value of Tobin's Q could mean that cash flow availability is high as well.
Thus, this study would be able to establish the relationship between Tobin's Q
with the firms' investment activities and available cash flow in a real context of
Malaysian's listed firms.
(vi) Cash account uses as defined by D'Esppallier and Lopez-Iturriaga (2009)
Cash account uses represents the expenditures of firms for purpose ofoperation. In
this respect, the cash account uses is considered rival to its investment activWes. It
is therefore expected that cash account uses would have negative relationship on
firms' investment. However, how significant such a relationship would be shall
only be known through this study.
(vii) Agency problem - expressed by shareholder' s equity in the management or
closely held stocks.
Agency problem give rise to firms ' management conflicts. Normally, the results of
such a conflict could cause the firm to produced undesirable financial
performance. Agency problem could also cause poor decision making process by
management especially with regards to making investment decisions. In this study,
it would be able to uncover the relationship between agency problem towards
firms' investment activities.
This study would be able to establish and make known the level of significant influence of
these independent variables on the firms' investment activities in the context Malaysian )
Public Listed firms.
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1.4 Scope of the Study
This study focuses mainly on the aspect of the fmancial value of finn's Investments and its
relationship with the respective Free Cash Flow. It is conducted on a sample of 110 finns
listed in the Bursa Malaysia. This represents slightly above 10% of the total listed companies
covering the sectors of Consumer Products, Industrial Products, Constructions, Trading
Services, Properties, Plantation and Technology. The Finance sector was excluded from this
study. The study is conducted over a period of 5 years from 2005 to 2009 only. Regression is
run on the model whereby finns' investment is taken as dependent variables and the others as
independent variables.
Investment shall only include the purchase of land and building as well as plant and
machinery. It shall exclude any purchase of shares, stocks and other financial securities. The
main independent variable in this empirical study is free cash flow. Free cash flow is the net
cash flow in excess of that needed to fund all positive NPV projects. The other independent
variables considered in this study were finns' accessibility to external capital, finns' size,
dividend payout, share market value, agency problem and current account usage. These
variables were referred to respectively as fmns' debt ratio, total assets, percentage of dividend
declared, market share value, amount of cJosely held shares and the amount of current account
expenditures. In the regression model, all high value variables were reduced by dividing with
fmns' total asset value.
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1.5 Significance of the Study
The result of this study would be able to provide an insight into the relationship between
firm ' s investment expenditures and the free cash flow for non-fmance finns listed on the
Bursa Malaysia. In addition, it would also be able to uncover the relationship between
investment-free cash flow with other variables such as finn's accessibility to external capital,
firm's size by measure ofthe total assets, agency problem through the amount of closely-held
shares, dividend payout, Tobin 's Q - which measures the finn's market value and the finn's
current account usage. It would also be able to provide the infonnation pertaining to the
firm's management of free cash flow with regards to the decision on investment activities and
funding.
The country's existing investment opportunities has been constantly being emphasized by the
government to be dependent heavily on foreign investors as reflected in the country' s Foreign
Direct Investments (FDI) from the annual report. At the same time, the government had also
been constantly providing incentives for domestic finns to invest from within. This was
evident through the government's annual budget allocation. However, the question remains
that state - would these opportunities being utilised by the domestic finns to the fullest? It is
therefore assured that this study would be able to provide some infonnation on the finn's
investment activities with regards to the variables related to it, especially the finn's free cash
flow. Therefore, from the result, it would be seen as to what extend would finns willingness
and capacity in exploiting the opportunities that had been made available by the government.
) The results of this study may also be useful for researchers in the same area to pursue further
and may adopt the figures which may be made available here.
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1.6 Limitations
The study is taken on a sample of 110 Malaysian Public Listed Companies from the various
sectors. This sample shall be taken as representation of the whole listed companies. As such,
the result of the study may not be really reflecting the true information on the companies as a
whole. True representation of the whole listed companies would require the study to be
conducted on every one of the listed firms and for a much longer duration of 10 years or
more.
This study is limited to the relationship and sensitivity of firm's free cash flow towards its
investment activities. The other independent variables in this study shall also be tested on the
influence or otherwise towards the sensitivity relationship between the abovementioned
variables.
1.7 Conclusion
Firms' investment is indeed an important component of expansion and income generating
process, which in tum, ultimately maximises shareholder value. However, the trend of
investment activities for the past 5-year period had been fluctuating and in fact reduced due to
the impact ofthe global economic downturn. This trend had actually enhanced the theory that
firms' investment is dependent on the cash flow. Therefore, the relationship between firms'
investment and free cash flow is expected to be significant. The next chapter shall describe
the various studies conducted on foreign firms pertaining to the relationship between firms'
investment activities to the various influencing factors.
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CHAPTER 2 - LITERATURE REVIEW
2.1 Introduction
Does firms listed in the Bursa Malaysia exhibits the relationship between the investment and
free cash flow in the same manner as most of the foreign firms? Many studies had been
conducted on foreign country's firms on this relationship. However, such information is seen
as not readily available for firms listed on Bursa Malaysia. In this chapter, various literature
reviews were conducted on firms' relationship between investment activities and various
variables. Among the variables were the firms' free cash flow, debt ratio, firm size, agency
problem, market capitalisation, dividend payout, cash account uses, regional disparity, sales
growth and use of derivatives. There are many more variables in this relationship which were
not covered in this study and were left out. From the literature review, the conceptual and
theoretical frameworks were established which would be use as the basis ofthis study.
2.2 Literature Review
Maximisation of shareholders value has been widely accepted as a principal, if not the only
bona fide aim of publicly listed firms (Pitman et aI, 2004). There is no doubt that all investors
want and expect good returns from their money. Managers are therefore vested with the
responsibility of maximisation of shareholders value. However, enterprise governance has
two dimension to it - that ofperformance as well as coriformance. Performance refers to the
maximisation of shareholders wealth as earlier stated. Conformance, on the other hand, refers
to the compliance to the set of responsibilities and practices exercised by effective
managements. These two governance goals clearly need to be kept in balance in order that
objectives are achieved and resources used responsibly.
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This study shall emphasize on the perfonnance side of finns' governance framework. This
management approach is often referred to as value-based management or VBM. VBM is
defined as a fonnal, systematic approach to managing companies to achieve the objective of
maximising value creation and shareholder value overtime (McTaggart, Kontes and Mankins.
1994). The most common avenue of maximising shareholders value is ofcourse by generating
good earnings with consistent growth. Thus, in order to achieve that, finns would embark on
investment activities that have already been identified to generate positive NPV returns.
Having the available investment opportunities requires finns to have sufficient cash flow to
be able to have the capacity to invest.
2.2.1 Investment and Free Cash Flow
In pursuing finns' main objective, managements were confronted with several decisions on
the activities to be executed. In the event of an investment opportunities arise, finns would
then be decided to embark on the investment activity. However, the subsequent step of the
decision making process would involve finns to source for fund in order to finance the
investment activity. One ofthe most common sources of fund for finns is from within, that is,
the firms' own cash flow. As such, the tendency for finns' investment activities to depend on
its own available cash flow is expected to be high. There have been studies made on the
relationship between investments and the cash flow. The relationship had also been expressed
in the form of the level of sensitivity, which means that investment is said to be either highly
or non sensitive towards the available cash flow.
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