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The management of any firm is charged with a responsibility of making the right decisions that would maximize the returns of an organization. In reality, firms do have profit targets, and sometimes they pay managers for achieving them, but the goals of firms are broader than their profits alone (Cheng & Wang, 2014).
Maintaining suitable amount of liquidity within the firms is fundamental for their smooth operations. Managers have a propensity to hold large percentage of firm assets in the form of cash and cash equivalents in order to reinvest on other physical assets, payments to stockholders and to keep cash inside the firm (Lee & Powell, 2011).The level of cash a firm maintains is described by its policies regarding capital structure, working capital requirements, cash flow management, dividend payments, investments and asset management.
(Jensen, 1992), defines free cash flow as cash flow in excess of what is required to fund positive NPV investments. Free cash flow is a sign of agency problems because excess cash may not be returned to shareholders. When firms have free cash, any acquisitions made by these firms are, by definition, negative net present value. Bowden and Posch (2011) state that free cash flows also can be defined for the entire firm. Specifically, free cash flows to the firm or simply free cash flows equal operating cash flows (adjusted for interest expense and revenue) less investments in operating assets. They continue to say that free cash flows to the firm reflects the added effects of investments and divestments in operating assets. The appeal of the free cash flows to the firm concept is that it represents cash that is free to be paid to both debt and equity holders.
Free Cash Flow can be expressed as: FCF=EBIT (1-Tax) + Depreciation ± Change in W.C- Capital Expenditure
FCF represents resources that managers have at their disposal to invest, but which could have been distributed among the shareholders. Free cash flows are vital as they allow a company to go after opportunities that shall lead to the enhancement of the shareholders’ value. This is because in the absence of cash, it’s a challenge to manufacture new products, minimize debt, pay dividends, and make acquisitions (Bhundia, 2012).
One key reason that many analysts use free cash flows for analyzing a firm is that earnings can be manipulated whereas free cash flow is very difficult to manipulate. Although, Investors should also be aware that companies can influence their free cash flow by lengthening the time they take to pay the bills (thus preserving their cash), shortening the time it takes to collect what’s owed to them (accelerating the receipt of cash), and putting off buying inventory. It is also important to note that companies have some leeway about what items are or are not considered capital expenditures, and the investor should be aware of this when comparing the free cash flow of different companies (Ilyas M. , 2014).
Negative free cash flow is not inevitably an indication of a bad company, however, since many young companies put a lot of their cash into capital expenditure, which diminishes their free cash flow. Although, if a company is spending so much FCF, it should have good grounds for doing so and it should be earning high rate of return on its investments. While free cash flow doesn’t receive as much attention as earnings do, it is considered by some experts to be a better indicator of a company’s financial health.
According to Bhundia (2012) allocation of free cash flows represents the greatest agency challenges. According to (Jensen, 1992), when an organization is able to generate huge volumes of FCF, then there will be a conflict of interest between managers and shareholders in regards to the dividend payout policy. Managers will make a promise that the future cash flows will be used to increase dividends but these promises shall not be adhered to as nothing will be present to prevent reducing dividends in the future.
A firm’s performance can be evaluated by studying the profitability, investment decisions and the market value of its shares. Profits are the bottom line in organisations and therefore we can look at the relationship between the firm’s profits and its free cashflows to evaluate the effect on performance. The relationship between free cashflows and investment decisions portrays a clear picture as to how free cashflows affect the firm’s performance as these investments are what generate revenues for the organization as well as enable analysts to judge the management of resources therefore the performance of the company. The market value, otherwise known as stock price, of a company’s share reflects the performance of the firm directly and therefore when we study the relationship with free cashflows, we are able to link performance to free cashflows.
Free cash flows is one of the key tools for measuring the financial performance of a business unit and shows the cash that company has after incurring the necessary costs for maintenance or development of assets (Habib, 2011).
Free cash flows can have important applications for shareholders in assessing the financial soundness of the business unit. The managers who invest free cash flows in projects with positive net present value (NPV) as a result of efficient use from their owned resources contribute to the increase of the firm value. Firms have a choice between internal and external sources to finance their investments. Internal sources include retained earnings and depreciation, while external sources refer to debt and equity (Chakravarty ; Mitra, 2010).
Cheng and Wang (2014) note that profitability of a firm means the ability to make profit from all the business activities of a firm or an enterprise. It shows how efficiently the management can make profit by using all the resources available in the market. According to Harward “profitability is the ability of a given investment to earn a return from its use.” (Cardoso, Martinez, ; Teixeira, 2014). Profit maximization is said to be the main objective of all firms.
Increasing profitability involves determining which areas of a financial strategy are working and which ones need improvement. One of the most frequently used tools of financial ratio analysis is profitability ratios which are used to determine the company’s bottom line and its return to its investors. Profitability measures are important to managers and owners of the firm since they show the overall efficiency and performance of firms. Profitability ratios can be divided into two types namely margin and returns (Mehur-un-Nisa & Mohammad, 2011).
FCF have a direct impact on the general worth of a firm therefore investors will be on the lookout for firms that have improving or high free cash flows. Strong/huge cash flows gives a company more flexibility whereas weak/low cash flows puts a company on the defensive by discouraging it in engaging in risk taking and aggressive exploitation of market opportunities (Kemboi, 2010).
Investment decision refers to the process of determining which investment projects result in maximization of shareholders value (Jamshidi, Lotfi, & Mohseni, 2014). Companies that have high free cash flow are likely to attract investors that look for efficient opportunities to invest their additional resources in the market. Creditors and investors are willing to invest in companies that have high free cash flows because the strength of debt kickback and definition of financial flexibility of the company are the means for assessing these companies. In addition, cash profits and debts reduction are not possible without possession of cash.
Investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decision. It is defined as the firms decision to invest its current funds mostly in the long-term assets in anticipation of an expected flow of benefits over a series of years. This includes expansion, acquisition, modernization and replacement of the long-term assets, sale of a division or business (divestment), change in the methods of sales distribution, an advertisement campaign, research and development programme and employee training, shares (tangible and intangible assets that create value) (Lee & Powell, 2011).
Market value is the cost of purchasing securities on an exchange. Market value which is also known as share or stock price fluctuates on a daily basis depending on the market’s forces of demand and supply. If shares of a company are in high demand due to the company performing well, then the price per share would increase. If there is a surplus of shares and little demand due to the company performing below par, then the price per share would decrease (Fama, Stock returns, Real activity, Inflation and money, 2010)
The stock price of a company in equilibrium is usually its value at that particular moment of its future cash flows. Share prices are always driven by index, a company’s financial health, economic trends and world news. The higher the cash flows taking into consideration revenues and collection of account receivables then the higher the stock price. This is because investors put more value in the cash flows and what those flows portray to them. Cash flows represents a vital factor in determination of stock prices because the ability to pay dividends depend on it as much as on the bottom line of the company (Manian & Fathi, 2017).
As a capital market institution, the stock exchange plays an important role in the process of economic development. The NSE began in the early 1920’s while Kenya was considered a colony under British control. It was an informal market place for local stocks and shares. By 1954, an official stock exchange was created when NSE was recognized by London Stock Exchange as an overseas stock exchange. NSE is licensed under the Capital Market Authority (CMA) with its main obligation to regulate the security market and ensure trading of securities by bringing together borrowers and investors at low cost. Regulation of quoted firms is achieved by ensuring that firms stand by the rules and regulations set by providing their periodic performance reports. NSE also provides information to general public on investment matters.
Trading activities are conducted through stock brokers who meet on the floor of NSE and facilitate the exchange of shares and bonds through auctioning process. In 2006, live trading on the automated trading systems of the NSE was implemented, to keep pace with other major world stock exchanges (NSE, 2018). Most firms listed at Nairobi Security Exchange have diversified their portfolios due to the nature of the business environment in order to remain competitive in the market (Kemboi, 2010). Through diversification firms have been able to experience growth in their assets, increase shareholders wealth and expansion of portfolios. This has been achieved through proper investment decisions and corporate governance. This however has limited firms from accessing free cash flow leading to an increase in investments.
The shares of sixty five companies listed at the NSE trade in the thirteen sectors namely: – agriculture, automobiles and accessories, banking, commercial and services, construction and allied, energy and petroleum, insurance, investment, investment services, manufacturing and allied , telecommunication and technology, real estate investment trust and the exchange traded fund market segment (NSE, 2018).
The NSE (Nairobi Securities Exchange) 20 share index is used to track the performance of the NSE equities (shares) market. The NSE 20 Share Index is a price weight index calculated as a mean of the shares of 20 public, listed companies. They are selected based on a weighted market performance during the period under review based the following criteria:
1. Trading activity measures weighed in the ratio of 4:3:2:1. I.e Market Capitalization 40%, Shares traded 30%, Deals/liquidity 20%, and turnover 10%.
2. A company must have a free float of at least 20%.
3. Must have a minimum market capitalization of Kshs. 20 million.
4. A company should ideally be a blue chip with superior profitability and dividend record.
The NSE 20 share index essentially cover the top 20 firms in the nation and this is a suitable index to study as all the shares are regularly traded and the firms come from various sectors enabling generalizations to be made.

Managers have a tendency to hold large proportion of firm assets in the form of cash and cash equivalents in order to reinvest on other physical assets, payments to stockholders and to keep cash inside the firm.
The problem related to free cash flows was discovered when it was apparent that managers did not invest the free cash flows to the advantage of shareholders rather they hold it and went for negative NPV projects which worked for their benefits, preferring bonuses and internal projects. Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital (Bingilar ; Oyadenghan, 2014).Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies (Haddad, 2001).
Om Sai Ram Centre for financial Management research, (2017) found out from their research that when explaining the stock prices by use of the U.S marker data, earnings are better than free cash flows. They found out that as long as companies are using operating cash flows of financial resources to invest in new projects, then it will encounter favorable response in the capital market thereby increasing the company’s stock price and market value hence portraying FCF and stock prices having a positive relationship.
Jamshidi, Lotfi, & Mohseni, (2014), found out that there exists a positive meaningful relationship between FCF, company performance and stock prices of firms listed at the Teheran Stock exchange. Thus these studies portray that FCF and stock price have a relationship that vary across different capital markets.
Studies have investigated on the implications of the free cash flow hypothesis on firm investment activity. Chen, Liu, & Chen, (2014)found that firms that had invested more held less free cash flow. According to them, firms with excess cash (measured using balance sheet cash information) had higher capital expenditures, and spent more on acquisitions, even when they appear to have poor investment opportunities
In the Kenyan context, Waithaka, Ngugi, Aiyabei, Itunga, & Kirago (2012), conducted a study on the effect of dividend policy on the share prices; it was found that that free cash flow caused conflict between management and shareholders which in turn affected the share price. Onsare (2013) and Kotut (2012) investigated on the link between investment rate and economic growth, the results of the study revealed that there was a positive relationship between investment rate and economic growth.
Firms in the Nairobi securities exchange have shifted focus to diversification in order to mitigate losses and increase profitability. The existence of an efficient market in Kenya has enabled most investors to take advantage of available information to invest in profitable investment and projects that are profitable. Listed firms are also focusing on ways of managing the working capital components in order to mitigate costs of running the firm ( (Onsare, 2013).
With recent cases of giant companies like Nakumatt Holdings Limited failing due to cashflow crisis (Wanjala, 2016), it has become necessary to study the effects of free cashflows on companies listed on the NSE 20 share index as they are the nation’s leaders in the sectors they belong to. The economy of the country essentially lies in their hands and studying this relationship will enable better investor decision making.
These studies did not investigate on the relationship between free cash flow and the performance of companies listed on the NSE 20 share index in terms of profitability, investment decisions and the market value. Therefore, this study attempts to determine what the effect of free cash flow is on profitability, investment decisions and the market value of firms listed on the Nairobi Securities Exchange 20 share index.
The general objective of this study is to determine the effects of free cash flows on the performance of companies listed on the Nairobi Securities exchange specifically those on the NSE 20 Index in Kenya.
The specific objectives of this study are:
1.5.1 To determine the effect of free cash flows on the profitability of companies in the NSE 20 share Index in Kenya
1.5.2 To determine the effect of free cash flows on the investment decisions of companies in the NSE 20 share Index in Kenya
1.5.3 To determine the effect of free cash flows on the market value of companies in the NSE 20 share Index
The findings of this study will benefit the following,
1.6.1 Foreign and Local Investors
The findings of this study will provide more insights to foreign and local investors on the effect of free cash flow on performance while considering investment decisions and diversification of portfolios to increase profitability. This study will enable both local and international investors to have more insight on the relationship between FCF and stock prices hence make sound investment decisions on which stocks to purchase so as to achieve profitable returns on their investments.
1.6.2 Financial Analysts
Financial analysts and consultants stand to benefit from the findings of this study; it will enable them provide improved financial services especially on investment decisions in order to achieve an increase profitability. Financial consultants and analysts will benefit from this study in that they will be able to identify firms which are performing well thus advise their potential clients on firms having high stock prices and returns which are good for investment.
1.6.3 NSE 20 share Index Constituents
Firms will be able to know whether investment decisions wholly rely on the free cash flows of the firm or not. This study will therefore enable the firms to have an external audit of their performance and make necessary policy changes to make better decision regarding investments in order to improve profitability and their market value.
1.6.4 Government and Regulatory agencies
The Kenya government and regulatory agencies will have more information on the effects of free cashflows that will assist it in policy formulation, such as monetary and fiscal policies to affect the interest rates and inflation so as to ensure that it protects its top performing firms.
1.6.5 Academicians and Researchers
This research study will add more knowledge to academicians and researchers who will intend to use the finding of this study as a basis of their research to either fill research gaps or contribute to their learning process. The study will also be useful since it will add more knowledge on the effect of free cash flow on performance of firms listed at the Nairobi Securities Exchange 20 share index.
The NSE consists of 65 firms in different sectors and if a keen eye is placed on the trading then only a few are frequently traded. It was therefore difficult to collect data on all of the constituents. Hence, this research was therefore based on the top twenty firms which make up the NSE 20 share index in order to gain an overall perspective of the market. The study was therefore carried out on the twenty firms and based on secondary data from the financial statement, auditor reports and press statements for the years ranging 2012-2017 in order to cover a five year period. The sectors represented did not include all the sectors in the NSE though the firms represented the cream of the market on which data is readily available.
1.8.1 Free cashflows :
Free cash flow is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, dividends, reducing debt, or other purposes. (Fama, Efficient capital markets: A revview of theory and empirical work, 2010)
1.8.2 Performance
Performance refers to the process of measuring the results of a firm’s policies and operations in monetary terms (Madura and Fox, 2011). For the sake of this study the performance will be measure based in the profitability, investment decisions and market value of the stocks.
1.8.3 Profitability:
Profitability of a firm means the ability to make profit from all the business activities of a firm or an enterprise. It shows how efficiently the management can make profit by using all the resources available in the market. (Cheng & Wang, 2014)
1.8.4 Investment decision:
Investment decision refers to the process of determining which investment projects result in maximization of shareholders value (Geng & N’diaye, 2012).
1.8.5 Market value:
Otherwise known as the stock price is the cost of purchasing securities on an exchange. Stock price which is also known as share price fluctuates on a daily basis depending on the market forces of demand and supply.
1.8.6 Return on Asset
Return on Assets (ROA) is a financial ratio that measures the profitability of a business in relation to its total assets (Jamshidi, Lotfi, ; Mohseni, 2014)
1.8.7 Return on Equity
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity (Madura ; Fox, 2011).
Chapter one examines the background of the problem then it identifies the problem of the research. The background of NSE and the NSE 20 index is also reviewed in this chapter. The general objective is derived from the research problem as to determine the effect of free cashflows on performance of firms listed on the NSE 20 share index. Therein are the specific objectives which help in answering the problem statement regarding the effect of free cashflows on profitability, investment decisions and market value. The research was useful to various parties like investors, analysts, regulatory bodies among others. The study was conducted on twenty companies listed in the NSE 20 share index for the period ranging 2012-2017. The next chapter will provide information on the literature review that was done with respect to the specific objectives formulated in this chapter. The following chapter involves the literature review based on the three specific objecctives of effects of free cashflows on the profitability, investment decisions and market value of firms listed in the NSE 20 share index.

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This chapter discusses a selection of the literature concerning the effects of free cashflows on performance of NSE 20 share index companies. It begins with a focus on effect of free cashflows on profitability constituting the determinants of profitability and other previous researches on the same. This is followed by the effect of free cash flows on investment decisions providing literature and the determinants of investment decisions. The third section covers effects of free cashflows on the market value of firms which also has its determinants. Lastly this chapter provides a chapter summary of the literature review.
Proper management of working capital components enables the firms to hold excess free cash flows which can in turn be invested in profitable projects to generate profits for the firm. Cutting of costs has a significant effect on the free cash flow held by the firm as it this permits the firm to have additional finances to take advantage of profitable investment projects that can yield higher returns. Free cash flow does not only impact on revenues and profitability of the firm but also the management of the balance sheet.
Recent research by (Ambreen ; Aftab, 2016) shows that there is a significant positive relationship between free cash flows and profitability, an increase in the level of cash flow of a firm leads to a corresponding increase in profits of the firm. This is achieved through investing. The firm should consider making key investment decisions to make use of additional cash flows. For example firms that hold excess cash might use it in buying overpriced firms rather than paying out dividends to the shareholders. This is possible even when the firms have a low financial capacity after making acquisitions since they invest in non profitable investment projects (Ambreen ; Aftab, 2016).
Firms can decide to hold free cash flows for speculative purpose as they wait for a profitable investment that can promise better returns in the future. The firm can also decide to invest in risky investments that have higher returns; these investments may later yield better returns which could be profitable to the firm. On the other hand, if poorly invested free cash flows can negatively impact the profits of the firm (Lachheb ; Slim, 2017).
Increasing shareholders wealth over a long term period remains the most pivotal objective that a firm pursues and improving its success will depend on whether a firm will be able to achieve favorable performance. Various methods have been used to measure the performance of firms and free cash flow has emerged as one of the newest methods (Mehur-un-Nisa ; Mohammad, 2011). According to Jensen, (1992), free cash flows is in excess of what is required for projects that portray positive NPVs when they are discounted at the relevant cost of capital. These projects represent long term investment plans that the present value of cash inflows is expected to be higher than the present value of cash outflows.
Positive free cash flows are usually an indicator that a firm will have cash surplus upon payments of its costs and investments. However a firm can have negative free cash flows which may be due to a mismatch of expenditure and income which is not always bad but its negative reasons should be analyzed. Capital markets usually react to the level of cash holdings in joint stock companies. Companies that regularly have excess cash earn lower returns to their shareholders as compared to companies that are randomly and periodically challenged with this issue (Lee and Powel, 2011).
Profitability is represented by various ratios like earnings before tax to total assets, net profit margin and many more. The variables that are used in an attempt to determine the firm’s profitability include size, leverage, sales growth, investment and current assets (Lachheb & Slim, 2017). Below are a few variables that determine profitability.
2.3.1 Size of the firm
Total assets and turnover, are commonly used as a substitute for size. Larger firms not only enjoy a higher turnover and therefore are able to generate higher income, but also have better access to capital markets and lower cost of borrowing ( (Ilyas & Jinnah, 2014)
Further, the nexus existing between firm size and performance has also received considerable attention in both theoretical and empirical research. Bowdden and Poscch ,(2011) argued that it is obvious for big companies to have more competitive power when compared to smaller ones since they have a bigger market share which makes this big firms have the opportunity to profit more.
For instance, an empirical study on the relationship between firm size and profitability by Niresh and Thirunavukkarasu, (2014) found no relationship between firm size and profitability of listed manufacturing companies in Sri Lanka. So their study emphasized that firm size has no profound impact on profitability of some categories of companies.
2.3.2 Leverage
Leverage is another determinant of profitability; it can be measured by using different financial ratios. (Tangjitprom, 2015) define leverage as either the ratio of total debt to total equity or the ratio of total debt to total assets. It is expected that leverage affects profitability negatively since higher debt values require more resources by the firm in order to repay the debt, reducing the funds available for investment.
A study conducted by Parsian & Amir (2013) investigated on the effects. This study provides empirical evidences by choosing a sample of 102 companies over the time span of 2005-2010. The result shows that independent variables of free cash flow and profitability current ratio have negative and significant impact on dividend payout ratio; whereas, the independent variable of leverage ratio has a positive and significant impact on dividend payout ratio
2.3.3 Sales Growth
Sales in growth is a significant determinant of profitability, sales growth of the firm is measured by the ability of the firm to achieve growth in sales, ceteris paribus, providing it with additional income for the current period, facilitating also its further expansion and is therefore expected to affect its profitability positively (Chakravarty & Mitra, 2010)
In his study, Habib (2011) surveyed 7,229 companies listed on the Australian stock exchange between 1992 and 2005. He studied the current cash flow, stable profitability and growth opportunities on the stock returns. The results of the analysis show that firms with greater growth opportunities and free cash flow will have a higher value price, and additionally free cash flow is positively related to stock return while profitability is short-term.
2.3.4 Investment
Physical capital investment is expected to affect profitability positively since it expands production, aiming at improving sales, cash flow and profit?generating ability. Using data available in financial statements and assuming that the majority of new investment is materialized through the increase of fixed assets, this variable is calculated as the growth rate of gross fixed assets in two consecutive years ( (Geng & N’diaye, 2012)

2.3.5 Current Assets
The inefficient management of current assets by a firm that is building up excessive stock or receivables that signal difficulties in either selling its products or collecting income from past sales

In a study carried out by woods ,(2016) in order to was establish the pattern of performance of listed takeovers and free cash flow. The results of the study revealed that there was an inverse relationship between performance of takeovers of listed domestic firms and free cash flow.
According to Bingilar and Oyadenghan (2014), there is a statistically significant and strong positive relationship between cash flow position and net profit and this made Bingilar, Oyadenghan conclude that cash flow position determines the extent of net profit performance of organizations in the hospitality and printing/media sectors.
In another study, Cardoso, Martinez, ; Teixeira, (2014)assessed the relationship between cash flow and financial performance of listed banks in emerging economies using Brazil as case study. Data was obtained from the annual reports and accounts of the selected banks and subjected to statistical analysis using correlation technique. The study outcome revealed that operating cash flow has a significant and strong positive relation with performance in the Brazilian banking sector. Further results also showed that investing cash flow and financing cash flow had negative and weak relationship. The authors therefore recommended that the Brazil financial regulatory authorities to scrutinize financial reports of quoted banks in and make external auditors use cash flow ratios to evaluate performance for the purposes of helping investors make the right decision.
In another interesting study, (Ogbeide ; Akanji, 2017)) empirically determined the impact of cash flow on a firm’s performance of a Nigerian food and beverage company. The result revealed investing cash flow had a significant negative relationship of corporate performance.
Wanja (2011) conducted a study on the relationship between the determinants of working capital management i.e. inventory, debtors, creditors, and the cash level of Kenyan SMEs. This research was conducted through a survey study. The target population of this study was the sampled 205 SMEs. Data was analyzed using a regression model and the results of the study found that firms with greater cash flow volatility hold more cash in order to provide a safe cushion for smooth operations.
Kemboi (2010) carried out a descriptive survey on listed firms in the capital market, a firm-level panel data for the period 2000-2008.Tests were based on fundamentals q investment equations in which cash flow and debt were added as explanatory variables. The results of the study revealed a significant positive relationship between debt and investment levels in both types of firms.
However, some of the empirical findings from these studies are mixed and inconclusive; thus necessitating further research on the subject matter. While some studies show that there is a negative relationship between cash flow and firm performance, others reveal a positive relationship between company’s performance and cash flow. Therefore this study is geared towards establishing whether empirical evidence is consistent with the hypothesis of the above studies by determining the effect of free cash flow on profitability of firms listed on the Nairobi securities exchange 20 share index.
Firms maximize their value through investment and this therefore is a motivation to the managers who own shares of the company (as a measure to tame the agency problem) to invest in projects that add value to the firm, which has a long-term or future perspective unlike issuing dividends to shareholders which motivates for now but if invested in positive NPV projects can increase the value of the firm and the shareholders wealth.
Capital expenditure is strongly and positively associated to the level of free cash flow (the more free cash flows a firm has, the more investments the firm can engage in.
Determinants of investments of listed firms
According to Vogt (1997),The most important determinant of capital expenditure is cash flow. Capital expenditure is strongly and positively associated to the level of free cash flow (the more free cash flows a firm has, the more investments the firm can engage in. In the IMF working paper Geng and N?diaye (2012), the empirical analysis of the determinants of investment indicates that financial variables such as interest rates and the exchange rate are important determinants of corporate investment, others include: capital stock and dividend policy or retention policy (not included in the paper).
2.4.1 Real interest rates
Rittenberg and Tregarthen (2014) state that real interest rates have a negative impact on investment that is higher interest rates increase the cost of the borrowing used to finance most types of investment expenditures this tends to reduce the quantity of investment, while lower interest rates increase quantity of investment. According to Geng and N?diaye (2012) at the aggregate level, a 100 basis points increase in real interest rates reduces corporate investment in China by about ½ percent of GDP. Based on these estimates, raising real interest rates to the level of the marginal product of capital net of depreciation would probably lower investment by about 3 percent of GDP. The estimated effect for China of real interest rates on investment is much larger than the average of the other 52 economies in the panel. The estimated impact of interest rates changes on corporate investment is about half as big when estimated based on the firm-level data. This could possibly reflect the smaller reliance of this sample (which are large, listed enterprises) on bank-intermediated financing.
(Qandhari, Khan , ; Rizvi, 2016)studied on the time series analysis of macroeconomic determinants of capital expenditure. They found that out of the seven macroeconomic indicators included in the study, only price inflation posed an inverse relationship with capital expenditure increase.
2.4.2 Exchange rate
An exchange rate appreciation lowers investment and vice versa as the exchange rate depreciates there is a corresponding increase in investments. As observed by Geng and N?diaye (2012) a 10% percent appreciation would reduce total investment by around 1 percent of GDP. The large concentration of manufacturing companies in the firm-level sample means that the estimated impact of exchange rate appreciation from the firm-level data is much larger.
2.4.3 Capital Stock
According to Rittenberg and Tregarthen (2014) the quantity of capital already in use affects the level of investment in two ways. First, because most investment replaces capital that has depreciated, a greater capital stock is likely to lead to more investment; there will be more capital to replace. But second, a greater capital stock can tend to reduce investment. That is because investment occurs to adjust the stock of capital to its desired level. Given that desired level, the amount of investment needed to reach it will be lower when the current capital stock is higher.
2.4.4 Dividend policy and Retention policy
Firms with high cash flow volatility are also those with the greatest potential agency costs. When cash flows are variable, it is difficult for investors to accurately attribute deviations in cash flows to the actions of corporate managers or to factors beyond management?s control. Thus, the higher the expected variance in cash flows, the greater the potential agency costs, and the greater the reliance on dividend distributions. The value of dividend payout as a guarantee against non-value maximizing investments should be greatest for those firms with the greatest cash flow uncertainty. Therefore, the agency cost theory predicts that firms with volatile cash flows would, on average, pay out a greater proportion of their cash flows in the form of a dividend (Nouri ; Gilaninia, 2017)
From cash flow sensitivity point of view prior studies reported that financially constrained firms accumulate higher cash holdings and retain greater portion of the cash earned during the period, which means that liquidity is more important when firms cannot raise funds from external market and liquid resources are required for investment in future profitable projects (Tangjitprom, 2015). Cardoso, Martinez, ; Teixeira, (2014) point out that firms facing financial constraints will save more cash today to fund future investment opportunities. Intuitively, increasing tendency of saving cash out of free cash flows will indicate the availability of profitable projects and financial constraints and hence will reduce the payout ratio of the firm, provided that firms? access to external finance is limited to a certain level.
The payment of cash dividends to shareholders now is the opportunity cost of retaining the internal funds and investing the same in projects that have positive NPV that have greater returns to the shareholders in the future. This is influenced by the shareholders view that is largely explained by the „bird in hand? theory, where the shareholder perceives the uncertainty of the future cash flows, which have a risk aspect in them.
According to Narenjbon, Mirzaie, ; Hojghan, (2016), firms that pay high dividends without considering investment needs may therefore experience lower future earnings, also firms that consider investment needs that have prospects of maximizing the shareholders wealth, either retain all internally generated funds or issue low dividends. This shows that there is a negative relationship between dividend payout and future earnings.
Khanji ; Siam, (2015) investigated the relation between earning management and the performance of companies. They realized that companies with strict earning management suffered from poor performance in initial offering. So after initial offering, managers
will be removed from the future program list. Zhou, Yang, ; Zhang, (2012) investigated the relation between free cashflows and financial performance in china. The results show that strict earning management is the reason of increasing suspicious of IPO companies and breaking down of prices. Manian ; Fathi, (2017) investigated the relationship between free cash flow, earnings management and the audit committee. The purpose of this study was to investigate whether a high level of free cash flow is associated with earnings management or not. Using 911 sample companies listed in the Tehran Stock Exchange in the year 2010, the results have confirmed the research hypothesis and suggested that an independent audit committee assists to the company with a high free cash flow to reduce the revenue from the increase in earnings management.
Bhundia, (2012) stated that free cash flows as a proxy for agency costs in their study. Their study observed that the firm leverage plays an important role in reducing the agency cost of free cash flow by reducing the free cash flow that is under the control of the manager.
Dwiyanti ; Dadan, (2017) used a panel data of over 116,000 firms in Indonesia (2000-2007) to test the investment sensitivity among working capital, cash flow and fixed assets. They observed that the companies with higher working capital will have higher investment sensitivity in working capital to cash flow and low investment sensitivity in fixed capital to cash flow. Because working capital will be changing all the time throughout the whole life of the project. However, the fixed assets are not as volatile as working capital. It suggests that an active management of working capital may help firms to alleviate the effects of financial constraints on fixed investment.
Ilyas (2014) in his study on the impact of capital expenditure on the working capital management of listed firms concluded that a positive and highly significant relationship exists between the working capital requirements and capital expenditure.
Aslani and Noori (2014) conducted a study to conclude if a relationship exists free cash flows and dividends. Their results showed that a relationship does exist between the two; this relationship is evident throughout the organization’s growth, maturity and decline stage. Jamshidi, Lotfi and Mohseni (2014) in their study suggested that the directors must have regarded for the flow of economic benefits for financial reporting within the company and the optimal use of resources.
Chen, Liu, & Chen, (2014) found that investment-cash flow sensitivities have completely disappeared in recent years. In short, while there remains disagreement about why investment and cash flow are related, much of the recent literature
Ambreen & Aftab, (2016) conducted a descriptive survey on the effect of free cash flow on dividend payout of 320 non financial firms listed in Karachi Stock Exchange in Pakistan, the study used a five years trend from 2001-2006 and it was concluded that firms with larger free cash flow pay larger dividends.
(Zhou, Yang, & Zhang, 2012), conducted a study in China in relation to internal cash flow and investment expenditure, a descriptive survey was carried out in 55 banks and secondary data was used using eight years trend. The results of the analysis showed that there was an inverse relationship between internal cash flow and investment expenditure among banks in China.
According to Narenjbon, Mirzaie, & Hojghan, (2016) the relationship between cash low and investment are based on sample-splitting between constrained and unconstrained firms taken from a single country. The degree of sensitivity appears to be greater. It extends the literature by examining from a number of perspectives the behavior of firms. The research article proposes a number of hypotheses that are explored in turn. A first possible reason is that firms in market-oriented financial systems show greater sensitivity to cash flow because borrowers and lenders operate at arms-length compared to those in relationship-oriented systems. A second possible cause for differences in response to cash flow across countries is that the samples of firms taken from each country might differ in composition with respect to particular characteristics, for instance size. Equally, the industrial type may be an important determinant of investment sensitivity to cash flow since industries differ considerably in terms of the size of firms, capital-intensity, borrowing capacity, openness and the durability of their output.
Geng & N’diaye, (2012) concluded that there is a positive relationship between internal funds and investment decisions due to the liquidity constraints faced by firms as a result of the gap between the cost of external financing and internal financing.
This suggests that financial constraints are strongest when financial development is low. The effect is weaker inside conglomerates and is probably not driven by the East-West difference. This is consistent with the idea that conglomerates ease internal financial constraints. Industries with few low liquid assets may experience bigger benefits of financial development (i.e. the cash flow coefficient is reduced more by financial development in low liquidity industries).
FCF per share portrays that a firm is able to pay debt, dividends, redemption of shares and ability to carry out business development. Majority of investors choose firms to invest in by taking into consideration the earnings of a firm while ignoring other fundamental factors that influence the stock prices of firms such as availability of free cash flows. Investors are usually very sensitive in regards to the negative earnings of a firm even in situations whereby firms increase their earnings. Hence this lead to majority of listed firms to be present their earnings in the best possible way. Therefore few research have been carried out to explain clearly the vital factors that affect stock prices of firms. In Kenya, research studies explaining the relationship between FCF and stock prices have not been carried out clearly and thus this research shall aim to fill this gap by doing this research study on all non-financial firms listed at the Nairobi Securities exchange.
Generation of cash is the main factor point for potential investors seeking various stocks. Asset values, dividends and earnings may be vital factors but a firm that is able to generate cash will fuel the growth of these factors .Higher free cash flows should be an indicator of rising or increasing stock prices. One method of determining the value of stocks is taking into consideration the ratio of stock price to FCF per share. Having a comparison of a firm’s ratio of price to FCF with those of other companies provides an analysis for relative value compared to the traditional price earnings ratio. Firms that have a low price to free cash flows ratio represent firms that have been neglected at attractive prices (Cardoso, Martinez, & Teixeira, 2014)
A firm’s share price which is low and FCF is increasing implies that its earnings and share value/price will increase. However if a firm has insufficient free cash flows, it shall be unable to sustain its growth rate thereby negatively affecting its stock price and this can lead to liquidation of the firm. Measuring a firm’s free cash flows portrays the appropriate management of the overall firm’s operations which includes various factors such as production, capital expenditures employee costs, inventory control, sales and employee costs. Screening of corporations which have effective and attractive levels of price to FCF leads to a vital method to shine light upon the more mature stock values (Cardoso, Martinez, ; Teixeira, 2014).
Ivanovska, Ivanovski, ; Narasanov, (2014) found that managers’ self-centered behavior can include the following; expensive expenditure on luxurious leasing space and involving themselves in unjustifiable mergers and acquisitions. Thus excessive free cash flow can lead to over investment problems because the FCF can be used to fund NPV projects. So as to address this issue of managers retaining earnings and investing in negative NPV projects,
Determinants of Stock prices of listed firms
Fluctuations in stock prices is observed on a day to day basis in the stock market. However, during various specific times of the year, stock prices usually appreciate every morning and this may happen to a variety of stocks for longer periods during the day. Thus this indicates the force of supply and demand determine stock prices (Mehur-un-Nisa and Nishat, 2011).
Fama (2010) stated that common stock returns are correlated with different macroeconomic variables of a country, which are inflation, money supply interest rate, and capital expenditure. The vital implication of his findings was that changes in stock prices can be predicted by the changes in the micro economic variables. The determinants of stock prices can be categorized from a different points of view which can be either internal (micro economic) or external (macroeconomic)
2.5.1 Dividend Policy
Dividend policy is a vital financial decision that involves payment of shareholders on their return on investments. The dividend payout ratio which is calculated as dividend as a percentage of earnings is a critical factor of dividend policy. A firm can decide to have a low or high payout ratio. A low payout ratio results in less dividends paid out to shareholders which results in more retained earnings, increased free cash flows, high capital gains but low stock prices as few investors will be willing to invest in firms paying low dividends whereas a high payout ratio will lead to reduced free cash flows, less retained earnings but high stock prices as more investors will be willing to invest in firms paying high dividends due to the attractiveness of the stocks to potential buyers thus demand for stock will increase leading to increase in stock prices (Miller et al.,1961).
2.5.2 Earnings per Share
Earnings per share represents that portion of a firm’s profit that is distributable and allocated to each outstanding equity share and is used to measure a firm’s profitability per unit of shareholder ownership. Majority of investors make their investment decision based on the earnings per share of a firm thus it’s a key factor in determining stock/share prices. Earnings per share is derived by subtracting the preferred dividends from the net income of a firm and dividing by the weighted average of shares that are outstanding. Earnings per share is a vital driver of stock/share prices. A firm that has strong earnings per share will see its stock prices rise significantly as the higher stock prices will lead to a positive impression of the firm’s products in the mind of their customers thus leading to great demand, increase in sales and higher earnings. However when a firm has a lower earnings per share it will experience low stock prices that shall result in low sales thus lower earnings (Salmanzadeh, Jafari, Anjomani, & Marefat, 2014)
2.5.3 Director’s influences
Directors of a firm usually have an effect on stock prices. When an influential director decides to step down form the board of directors, it may create an atmosphere of doubts in the minds of the public regarding the financial stability of the firm thus can create a slump in the stock prices of the firm as investors may shun investing in the firm (Ilyas ; Jinnah, 2014). The decisions that directors of a firm execute in various areas of the business shall have an impact on investors and stock prices. Incorporating a new growth strategy perspective, expanding into new markets and introduction of new products will positively affect the stock prices of a firm as investors interpret the implemented strategies of director’s positively thereby increasing the stock price of the firm leading to improved profitability of the firm.
2.5.4 Insider Trading
This is a vital factor that affects stock prices of firms. It mostly benefits a small portion of investors who are either firm employees or individuals closely related to the firm’s management. Thus insiders shall buy and accumulate a firm’s stock before an important corporate announcement is made and sell their stocks after the announcement is done hence registering huge profits at the expense of other investors as the price of company stock increases. However engaging in insider trading is unethical and unfair because few investors will have unfair advantage over others as they have at their disposal information about the firm which is price sensitive (Cardoso, Martinez, & Teixeira, 2014)
2.5.5 Interest Rates
Interest rate is explained as a measurement of time value of money that is one of vital determinants of stock prices. Various changes in interest rates can lead to difficulties for investors and affect a firm’s profitability thus lead to fluctuations in stock prices. Lee ; Zhao, (2014) argued that the sensitivity of interest rate varies according to the term of interest rates which are usually long and short term interest rates. Through their findings they concluded that banks have stock returns that have a higher sensitivity as compared to non-financial stock returns.
2.5.6 Economic Growth
Economic growth represents a positive change in the output or production of a country’s economy in regards to inflation. It is calculated as a percentage increase in the gross domestic product (GDP) of a given economy and inflation is also considered in its calculations. Positive economic growth is an indication of a wealthier economy whereby there is increased production of goods and services thus leading to increase of stock prices of firms which results in increased profits for the firms thereby translating to reduction in unemployment and increased prosperity of an economy.
Khanji & Siam, (2015) suggested that various developments in stock prices should be considered when forecasting output. However, it should also take into account that the relationship between stock returns and economic growth has not always been stable over time
For example, Cheng (2015) argued that a certain number of systematic economic factors significantly influenced the U.K stock returns.
2.5.7 Inflation Rates
Inflation occurs due to a steady increase in the prices of goods and services against the normal standard level of purchasing power and as this occur, the supply of goods and services declines along with the devaluation of money. High levels of inflation rates predicts a financial crisis which leads to companies auctioning their stocks thereby leading to increment in supply of stocks hence reducing the stock prices because the companies will be compelled to sell their stocks at low prices due to the high inflation rates (Chakravarty et al., 2010)
2.5.8 Exchange Rates
Exchange rate refers to the rate at which a nation’s currency can be converted into another currency of a different nation. Various factors such as inflation, interest rates stability of a country can influence the exchange rate. Depreciation may increase the cost of imports leading to increase in domestic price levels, which would lead to stock prices having a negative impact (Jensen, 1992)
(Om Sai Ram Centre for financial Management research, (2017) examined the content of cash flows information by studying its connection with the high returns on stocks in the United States. The study was able to show that changing the power of the affected contents would be affected by dividing accounting income into accounting accruals and operational cash flows. It portrayed there existed a positive relationship between stock returns and operational cash flows, while a negative relationship existed between cash flows and financing.
Haddad, (2001) examined the relationship between cash flows and high returns on stocks by applying multiple and simple regression analysis. In accordance with IAS 7, Jordan’s companies Law requirements and Jordan securities commission’s regulations from Amman Stock Exchange the study sample measured cash flows. It sampled 44 industrial and services companies listed on the Amman Stock Exchange between the periods 1993 to 1998. The results portrayed that there existed no relationship or correlation between cash flows from financing, operating, or investing activities and high returns.
Khraywesh, (2001) examined the effect of cash flows on the market values of the stocks of Jordanian banks and public shareholding companies and the relationship between cash flows and stocks of banks and the effect that cash flows had on the financial position of the mentioned firms and their achievements. The study sampled 16 public shareholding financial corporations listed on the Amman Stock Exchange in 2002, that were in existence before 1988 and which had stocks that were traded for a period of four years from 1998 to 2001. The study applied the multiple regression analysis model in measuring the variables and concluded no significant relationship existed between the net cash flows and stock’s market value and that net cash flows came into effect due to long and short term obligations on one side, and ownership rights on the other side.
Ivanovska, Ivanovski, & Narasanov, (2014) conducted a study on the impact of distribution of dividends based on stock prices and the trading volumes of firms listed on the Macedonian Stock exchange for the period between 1997 and 2004. The study sampled eleven listed companies and studied vital changes in trading prices and volumes one month ahead and two months ahead after announcing dividends. The study came to a conclusion that a relationship that is statistically in nature exists between trading volume and the profit distribution decision, while there was no relationship with the stocks market value.
Haddad, (2001) examined the impact and behavior of operating cash flows on the financial rates which are common and the ones that are mostly affected by the operating cash flows. For the period between 2000 and 2006 the study sampled 49 industrial firms and used a uniform model when testing all firms. By using the method of simple regression analysis, the study found that there existed a statistically significant relationship between the operating cash flows and returns per share, book value per share and dividends, and found out that there existed a negative relationship between operating cash flows and stock turnover rate.
Njuguna and Moronge (2013) examined the impact of the managerial behavior of agency cost in regards to the performance of firms listed at the NSE. The study used multiple regression analysis on the contents of agency cost namely managerial ownership, debt ratio, information asymmetry, and board composition on the performance of listed firms. The study findings revealed that non-conforming information is another source of agency problems that the firm’s good performance depends on the importance of knowledge that a decision maker has. Further findings showed that free cash flow and information asymmetric problems are related to agency problems in a firm and short term debt bank debt are expected to portray vital corporate governance.
Musau , (2007)observed a strong trend in the NSE in the year 2006. He examined that increase in the earnings tend to lead to increase in the demand of shares all together. Thus the price appreciation resulted in stock splits. Various companies in Kenya such as Centum Investment Company, Kenol Kobil usually split their highly priced stock in order to make them affordable to the general public and also to benefit the investors as well as the company itself.
In Kenya, few research studies relating to investment decisions have been done, but clear research study on the relationship between free cash flows and investments has not been carried out in Kenya, therefore this research seeks to fill this gap by doing this research study on firms listed at the Nairobi Securities Exchange. The focus is on free cash flows although they have not receive as much attention as earnings do, they are considered by some experts to be a better indicator of a company’s financial health.
Chapter two examines relevant studies on the research topic and their findings. This chapter gives a background on the topic of research that various authors have come up with on the topic of study. Cases in which the topic of study was investigated have also been examined and conclusions from those studies related to the current study. The next chapter covers research methodology which specifies the research design, provides the population and sampling design as well as the data collection and analysis, research procedure and lastly a chapter summary.

3.2 Introduction
This chapter describes the research methods and designs that were used in collection of data to identify the effects of free cashflows on performance of NSE 20 share index listed companies as well as analyze findings and recommendations from the collected data. The chapter first looks at the research design used for guiding the research. This is followed by the identification of the population and sampling design. This describes the sampling frame, sampling technique, and the sample size. The data collection, research procedure and then the data analysis are then clearly identified and finally a chapter summary is provided.

3.3 Research Design
The descriptive research design was used in this study. One of the goals of descriptive research was to estimate the percentage of units in a specified population exhibiting certain behavior (Okutoyi, 2012). The term descriptive research refers to the type of research question, design and data analysis that will be applied to a given topic. Descriptive research designs are used when the objectives are systematic or descriptive of facts and characteristics of a given population or sample of the population or area of interest is factual and accurate. Descriptive research design seeks to uncover the nature of factors involved in a given situation, the degree in which it exists and the relationship between the study variables (Mugenda & Mugenda, 2003). This form of research was therefore found appropriate in determining the effects of free cashflows amongst the twenty firms on the NSE 20 share index.

3.4 Population and Sampling Design
3.4.1 Population
Population is the aggregate or totality of all subjects or members that conform to a set of specifications (Lee & Zhao, 2014). The target population consisted of the twenty companies listed on the NSE 20 share index. Below is a summary of the population:

S.No. Company Name
1 ARM Cement
2 Bamburi Cement
3 Barclays Bank Kenya
4 Britam
5 British American Tobacco Kenya
6 Centum Invest
7 CfC Stanbic
8 Co-operative Bank
9 East African Breweries
10 Equity Group
11 KCB Group
12 KenolKobil
13 Kenya Airways
14 Kenya Electricity Generating
15 Kenya Power Lighting
16 Nation Media
17 Safaricom
18 Sasini
19 Standard Chartered Bank
20 WPP-Scangroup

3.4.2 Sampling Design
The process of selecting a portion of the population to represent the entire population is known as Sampling. Research differs greatly in value according to how the respondents are sampled. Sampling is the process of selecting sufficient number of the right elements from the population so that a study of the sample and an understanding of its properties or characteristics make possible for the researcher to generalize such properties or characteristics to the population elements (Bougie and Sekaran, 2013). Sampling Frame
The sampling frame is a physical representation of all the elements in the population from which the sample is drawn. Although sampling frame is useful in providing a listing of each element in the population, it may not always be current. (Mugenda & Mugenda, 2003). The sampling frame of this study will be the companies listed in the NSE 20 share index as follows:
S.No. Company Name
1 ARM Cement
2 Bamburi Cement
3 Barclays Bank Kenya
4 Britam
5 British American Tobacco Kenya
6 Centum Invest
7 CfC Stanbic
8 Co-operative Bank
9 East African Breweries
10 Equity Group
11 KCB Group
12 KenolKobil
13 Kenya Airways
14 Kenya Electricity Generating
15 Kenya Power Lighting
16 Nation Media
17 Safaricom
18 Sasini
19 Standard Chartered Bank
20 WPP-Scangroup Sampling Technique
A sample is a group selected from a population (Naik, Ganasala, & Prabhakar, 2010). Inferences about a population can be made from information obtained in a sample when the sample is representative of the population (Naik, Ganasala, & Prabhakar, 2010). Samples based on planned randomness are called probability samples. Probability sampling has a certain amount of randomness built in so that bias or unbiasedness can be established and probability statements could be made about the accuracy of the methods (Mugenda & Mugenda, 2003). Randomization inherent in probability sampling helps balance out variables that cannot be controlled or measured directly. Reflecting on the small size of the population the entire population will be used as a sample. This is following the rule of thumb saying that if the population size is less than 100 the entire population should be used as the sample. Therefore the sample size for this study will be 20. Sample size
Following the sampling technique it is clear that the sample size for this study was 20 following the rule of thumb.
3.5 Data Collection
Since this research requires secondary data only, the data collection will involve information from the companies’ financial statements, auditor reports, press statements and various other secondary sources for the years 2012-2017. In order to ensure the usage of the data the authenticity of the documents will be confirmed and the data will be checked for completeness and timeliness so that all the data used is current and relevant.
3.6 Research Procedure
Due to the fact that no special permissions were required to conduct the study, I obtained permission form United states International University Africa to go ahead with the secondary study. I then obtained the required financial statements form Nairobi Securities exchange website and the relevant company websites. I then ensured the viability of the data collected and then started on the qualitative analysis of the data. Upon finishing a report was written and submitted for review after which a final copy was sent for approval from the dean. A copy of the final document was also sent to the companies under research.
3.7 Data Analysis and Presentation
The collected data was cleaned, edited and entered into an excel workbook and SPSS version 24 in order to enable easy analysis of the collected data. The process was made easier by coding the data according to each variable of the study. Hence this showed descriptive and inferential statistics which clearly showed and explained the effects of free cashflows on each variable and therefore the overall performance of the firms. Some of these descriptive statistics were the correlation which showed the relationship between free cashfllows and the variables, variance which showed the spread of the variables like stock price and profits due to the effect of free cashflows and Regression to look at the relationship and strength of these relations and the chi square matrix that showed the effect of the changes in free cashflows based on different groupings.. There was use of tables and graphs to analyze the effects of free cash flows. Tables and figures were used to give a clear picture of the research findings and gave quantitative information at the end.
3.8 Chapter Summary
This chapter highlighted research methodology that was used in the course of the study. This chapter included the research design which described how the data collection was conducted, where, how, when and why this research was being conducted. Population and sampling design identified the population and sampling techniques used. This chapter also described the different methods of data collection and how it was presented. It highlighted the statistical techniques to be used to analyze and present this data.

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