Measurement of Impact Agency Costs Level of Firms on Dividend and Leverage Policy: An Empirical Study

Transcription

1 Measurement of Impact Agency Costs Level of Firms on Dividend and Leverage Policy: An Empirical Study Dr. Ghassan Al Taleb The World Islamic Sciences University -Jordan College of Finance & Business Tel.No: Jordan - Amman Abstract Dividend policy is one of the most important areas in finance literature. This is known as dividend puzzle in finance literature. One explanation is that dividends help address agency problems between managers and outside investors. The agency problem analysis arises from managers incentives to consume private benefits, e.g., building their empires by investing free cash flows in negative net present value projects or spending cash on perquisites. Thus, dividends alleviate this problem by reducing free cash flows available to managers. This paper examines dividend policy of industrial firms and chose sample 60 industrial firms listed Amman Stock Exchange from 2007 to 2011 in order to test the free cash flow hypotheses. Based on the regression analysis shows a negative and statistically significant effect of free cash flow on dividend, while for a positive and significant effect of free cash flow on leverage. when examine the effect of risk, leverage, growth opportunity, free cash flow, size, retained earnings to book value of equity and profit as the measurement level of agency costs present in firms for testing the impact of agency cost on dividend policy Specifically, the free cash flow has negative influences but leverage and profitability variables appear to have positive influences on dividend payouts of Jordan firms Key Words: Agency Costs, Dividend, Leverage JEL Classification Code: L1, G10, G30 1. Introduction Many researchers have studied why firms pay a substantial portion of their earnings as dividends if, according to Miller and Modigliani s (1961) dividend irrelevance proposition, dividend policy does not change shareholders wealth. This is known as dividend puzzle in finance literature (Black, 1976). One explanation is that dividends help address agency problems between managers and outside investors. In Easterbrook s (1984) analysis, the monitoring role of dividends mitigates agency conflicts between managers and shareholders. The agency problem in Jensen s (1986) analysis arises from managers incentives to consume private benefits, e.g., building their empires by investing free cash flows in negative net present value projects or spending cash on perquisites. Thus, dividends alleviate this problem by reducing free cash flows available to managers 234

2 Dividends, the reward to shareholders in return of their investment and risk exposure, depends on various factors. Primarily, these factors are profit level, financing limitation, investment chances, firm size, shareholders pressure and regulatory regimes. When company makes a decision regarding dividend payouts, one important subject of interest is the understanding its relationship with the share price of the company. This relationship between stock returns and dividends have been documented on in various studies. However, the justification of commonly observed findings has been controversial and come up with two different questions; Is higher stock price a result of higher dividend payouts and vice versa? What is the influence of dividend announcements on the stock market? The first question is known as clientele problem and the second is ex-date effects on dividends. In clientele effects, the studies assume that some classes of investors select different levels of dividends due to their different levels of taxation. The agency costs of debt have been widely discussed, but the benefits of debt in motivating managers and their organizations to be efficient have been ignored. I call these effects the control hypothesis for debt creation. Managers with substantial free cash flow can increase dividends or repurchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or wasted. This leaves managers with control over the use of future free cash flows, but they can promise to pay out future cash flows by announcing a permanent increase in the dividend. Such promises are weak because dividends can be reduced in the future. The fact that capital markets punish dividend cuts with large stock price reductions is consistent with the agency costs of free cash flow. Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows. Thus, debt can be an effective substitute for dividends, something not generally recognized in the corporate finance literature. By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increases. In doing so, they give shareholder recipients of the debt the right to take the firm into bankruptcy court if they do not maintain their promise to make the interest and principal payments. Thus debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. These control effects of debt are a potential determinant of capital structure.( Michael C. Jensen,1986) 2. Literature Review The finding of Adaoglu (2000) states that the main determinant in the amount of cash dividend in the Istanbul Stock Exchange is earning for the same year. Any changeability in the earning of the company is directly reflected in the level of cash dividend. La Porta et al. (2000) compared to countries that have strong legal protection for shareholders with those who are poor legal protection of shareholders, and related that for countries with low quality of shareholder protection laws. Their conclusion is that 235

3 shareholders will take whatever they can obtain cash dividends from company profits, in which the dividend is deemed unstable According to La Porta et al. (2000), Thailand is characterized as a country with low shareholder protection. Further, the ownership structure of Thai firms is highly concentrated These characteristics can increase the agency costs of free cash flows and dividend payments are more likely to be used as a mechanism that helps mitigate this agency problem. The distinct institutional feature of Thai firms is a major reason why dividend policy in Thailand is of interest for examination in the context of agency costs of free cash flows. Fama and French (2001) study the propensity to pay dividends of U.S. firms between 1926 and They find that the percentage of firms paying dividend declines substantially after 1978, i.e., the proportion of dividend payers reaches its peak of 66.5% in 1978 but falls to only 20.8% in Their evidence indicates that the lower proportion of dividend payers is, in part, due to a surge in new listings of small firms with low profitability but high investment opportunities that never pay dividends. Studies result regarding relationship between dividend payout and free cash flow are the following. La Porta et al. (2000) explained that if the company had free cash flow, the managers will engage in wasteful practices, even when the protection for the investor increased. Meanwhile, the studies of Holder et al. (1998) and Mollah et al. (2002) have suggested that companies with a higher free cash flow should pay more dividends to decrease free cash flow agency costs. Baker et al. (2007) report that Canadian dividend paying firms are significantly having greater cash flows. Amidu and Sawicki (2005) illustrated that dividend payouts can help to ultimately monitor the performance of managers in large firms. That is, in large firms, information asymmetry increases due to ownership dispersion, decreasing the shareholders ability to monitor the internal and external activities of the firm, resulting in the inefficient control by management. Paying large dividends can be a solution for such a problem because large dividends lead to an increase in the need for external financing, and the need for external financing leads to an increase in the monitoring of large firms, because of the existence of creditors. Eriotis (2005) reports that the Greek firms distribute dividend each year according to their target payout ratio, which is determined by distributed earnings of these firms. In investigating the determinants of dividend policy of Tunisian stock Exchange, Nacelur et al. (2006) find that the high profitable firms with more stable earnings can manage the larger cash flows and because of this they pay larger dividends.abor (2006) find dividend payout policy decision of listed firms in Ghana Stock Exchange is influenced by cash flow position of the firms. DeAngelo et al. (2004) document highly significant association between the decision to pay dividends and the ratio of earned equity to total equity controlling for cash balance Baker et al. (2007) finds that Canadian dividend paying firms are significantly having some growth opportunities. Amidu and Abor (2006) find dividend payout policy decision 236

4 of listed firms in Ghana Stock Exchange is influenced by growth scenario and investment opportunities of the firms A recent study of Denis and Osobov (2008) also document the ratio of retained earnings to equity as a significant factor affecting dividend policies in six developed financial markets (the U.S., Canada, the U.K., Germany, France, and Japan). However, little is known about the impact of earned/contributed capital on dividend policies in emerging economies. Therefore, this paper aims to provide additional evidence of the effect of earned/contributed capital on dividend policy from an emerging market like Thailand Recently, Denis and Osobov (2008) examine cross-sectional and time-series evidence on the propensity to pay dividends in six developed financial markets (U.S., Canada, U.K., Germany, France, and Japan) over the period Free cash flow (FCF) is estimated by cash flows from operations following Baba (2009). If the managers pay dividends to mitigate agency cost of free cash flows, a positive relation between free cash flows and dividend payouts is predicted. On the other hand, a negative relation between free cash flows and dividend payouts might indicate the agency problem The hypotheses for this study are formulated as: Hypothesis 1: There is no impact of free cash flow on dividend policy Hypothesis 2: There is no impact of free cash flow on leverage Hypothesis 3: There is no impact of the level of agency costs present in firms on dividend policy this hypothesis include: Hypothesis 3-1: There is no impact of free cash flow and dividend policy Hypothesis 3-2: There is no impact of leverage and dividend policy Hypothesis 3-3: There is no impact of growth and dividend policy Hypothesis 3-4: There is no impact of profit and dividend policy Hypothesis 3-5: There is no impact of size and dividend policy Hypothesis 3-6: There is no impact of risk and dividend policy 3. Data and Methodology Archival research methodology was used in this study using publicly available archival data.basically the regression model was applied on Amman Stock Exchange in Jordan on the data of industrial firms. The sample is 60 listed in (ASE). The objective of testing hypotheses 3 is to examine the effect of free cash flow, leverage, growth, profit, size, and risk as the measurement of agency costs level of firms for testing the impact of agency cost on dividend policy. DIV = αit+ β1*fcf+ є it (1) LEV = αit+ β1 *FCF+ є it (2) DIV = αit+ β1*fcf+ β2*lev+ β3*gro+ β4*pro+ β5*siz+ β6*ris+ β7*re/te + є it (3) 237

5 The measurement of each variable is as follows. The dividend payout ratio (DIV) indicates the percentage of profits distributed by the company among shareholders out of the net profits, or what remains after subtracting all costs (e.g., depreciation, interest, and taxes) from a company s revenues. Most of the previous studies that investigated the impact of agency theory employed dividend payout ratios as a determinant of dividend (Mollah et al., 2002; Manos, 2002; and Travlos, 2002). In this study, we measured dividend payout ratio as cash dividends divided by stock price. Free cash flow (FCF) is a measure of how much cash a company has for ongoing activities and growth after paying its bills. In this research, free cash flow is calculated as net profit minus changes in fixed assets minus changes in net working capital, divided by total Assets. Debt to equity ratio (LEV) has been used as a proxy by the existing studies (for example Jensen et al., 1992). In our research, leverage ratio is also measured as the debt to equity ratio. Growth (GRO) rate is measured as the growth rate of sales (Jensen et al., 1992; Holder et al., 1998; Chen et al., 1999; Manos, 2002; and Travlos, 2002). In this study, we measured firm s growth as sum of total asset and market value of equity minus total equity divided by total asset. Profitability (PRO) is the ratio of net profits to the amount of money that shareholders have put into the company. Return on equity has been used in several studies as a proxy for firm profitability (Aivazian et al., 2003, ap Gwilym et al., 2004.) and I calculated it as net profit divided by shareholder s equity. I measure firm size (SIZ) as a natural logarithm of market capitalization. This is due to the fact that large firms will pay large dividends to reduce agency costs (Eddy and Seifert, 1988; and Redding, 1997). Finally, for measuring risk (RIS), Huang and Song (2002) used standard deviation of earnings before interest and taxes. Earnings volatility measures the variability of the firm's cash flows as a proxy for the costs of monitoring managers and of the risk of an insider's position. In this study, risk is measured as standard deviation of the firm's return on assets over a period of three years Retained earnings to book value of equity (RE/TE). The life-cycle hypothesis posits that firms in maturity stage with higher accumulated profits tend to pay higher dividends. Thus, RE/TE, a proxy for firm s life cycle, is predicted to have a positive relation with dividend payouts 4. Empirical Results and Discussion The purpose of testing hypotheses 1 and 2 is to determine to what extent the effect of agency cost of free cash flow on dividend payment and leverage so that it can indicate that management of firms can minimize agency costs of free cash flow by paying dividend to the shareholders and by using leverage. The following models will be used to test the respective hypotheses 238

6 Table 1: Regression Analysis Result Model (1&2) Std.Coefficient t-statistic Probability β DIV = α+ β1*fcf+ є Constant FCF *** LEV = α+ β1*fcf+ є Constant FCF ** Note: Asterisks (*) and ( **) AND (***) indicates significance at 1%,5% and 10% respectively. Table 1 shows a negative statistically and significant effect of free cash flow on dividend with t-values and at significance level 10%. It implies that, firms with higher free cash flow tend to decreased dividend payment to reduce free cash flow problems. On the other hand, we find a positive and significant effect of free cash flow on leverage with t-values and at significance level 1%. It explains that, firms with higher free cash flow are likely to use more leverage to reduce agency costs. Therefore, based on these results, our firms sample are consistent with the theory which argues that leverage is a more effective way to mitigate the free cash flow problem than dividend payments, because of the contractual obligation to pay periodic interest on debt and repay the borrowed capital at maturity. However, it has been argued that both of the contractual payments associated with debt and discretionary dividend payments to shareholders, can reduce the agency cost of free cash flows by reducing the cash flow available for spending at the discretion of managers (Stulz, 1990 ; and Harris and Raviv, 1990). Table 2: Regression Analysis Result Ind. Variables Std.Coefficient.β t-statistic Probability Constant FCF *** LEV ** GRO PRO ** SIZ RIS RE/TE * Note: Asterisks (*) and ( **) AND (***) indicates significance at 1%,5% and 10% respectively. R 2 Adjusted R 2 Durbin-Watson F-Statistic Prob(F-statistic) 239

7 Table 2 shows the coefficient of determination, or simply R-squared. Its value is always between 0 and 1, and interpreted as the percentage of variation of the response variables explained by the regression line. Adjusted R-squared shows predictors risk, leverage, growth, free cash flow, size, and profit of with dividend as dependent variable. This means that 34.2% of the reasons why the firms pay dividend could be explained by the predictors And this Table presents regression results of agency cost variables on dividend. The regression result reports a negative statistically significant effect of free cash flow on dividend. The significant value on this variable is with t-value of It indicates that firms with high free cash flow tend to decrease dividend payment. It also shown by the correlation matrix those profitable firms with high free cash flow tend to pay less dividend. If the managers pay dividends to mitigate agency cost of free cash flows, a positive relation between free cash flows and dividend payouts is predicted. On the other hand, a negative relation between free cash flows and dividend payouts might indicate the agency problem While the regression result shows a positive significant influence of leverage on dividend with the significant value of and t-values. It indicates that firms with high leverage tend to increase dividend payment. The correlation matrix implied that firms with high leverage have insignificant high free cash flow. Since firms with higher debt ratio are more likely to be financially constrained and should be less able to pay dividends, the free cash flow hypothesis predicts a negative relation between debt ratio and dividend payouts. On the other hand, we find a negative but insignificant impact of growth opportunity on dividend with level of significance and t-values. The interpretation of this result is that firms with lower growth opportunities tend to pay dividends in order to reduce agency costs. Following Fama and French (2001), AGR and MTB are used as proxies for current and future investment opportunities respectively. The free cash flow and life cycle hypotheses predict a negative relation between investment opportunities and dividend payouts Regarding profit and dividend, result shows a positive and significant effect of profit on dividend. The significant value on this variable is with t-value of It indicates that firms with high profit tend to increase significant dividend payments. The regression result also shows a positive insignificant effect of size on dividend. The significant value on this variable is and t-values. It indicates that large firms tend to increase insignificant dividend payments to reduce agency costs. In general, this result is consistent with the study results of Fama and French (2001), which conclude that size is expected to have a positive effect on dividends. As size may also be a proxy for the information that outside investors have, Fama and Jensen (1983) argue that larger 240

8 firms tend to provide more information to lenders than smaller ones. Rajan and Zingales (1995) also argue that larger firms tend to disclose more information to outside investors than smaller ones. Therefore, larger firms with less asymmetric information problems should tend to have more equity in their capital structure. The free cash flow and life-cycle hypotheses posit that, compared with smaller firms, larger firms tends to be more mature and have higher free cash flows, so they are more likely to pay higher dividends. Thus, the free cash flow and life-cycle hypotheses predict a positive relation between firm size and dividend payouts. While a positive but not significant influence of risk on dividend with t- values and at significance level. It implies that firms with higher risk are likely to pay dividends to reduce agency costs. In general, this result is inconsistent with the results of previous studies which predict that firm with higher risk as likely to decrease dividends payment to shareholders (Hoberg and Prabhala, 2005; Jagannathan, Stephens, and Weisbach, 2000). Finally, find retained earnings to book value of equity (RE/TE) a positive but not significant influence of risk on dividend with t- values and at significance level 5. Conclusion Dividend policy is at the very core of corporate finance. The fundamental value-relation of corporate finance is couched in terms of dividends: the value of an all equity firm is equal to the present value of all future dividends. Therefore it is not surprising that in a recent survey on dividend policy, Allen and Michaely (1994) cite close to 100 articles. Despite this voluminous literature, a number of key issues remain unresolved and clear guidelines for an optimal payout policy have not emerged This paper examines dividend policy of industrial firms and chose sample 60 firms listed Amman Stock Exchange from 2007 to 2011 in order to test the free cash flow hypotheses. Based on the regression analysis, the evidence from this research provides much support for the free cash flow and dividend hypotheses. The result show the impact of agency cost of free cash flow on dividend payment and leverage. I find a negative and statistically significant effect of free cash flow on dividend, while for a positive and significant effect of free cash flow on leverage. when examine the effect of risk, leverage, growth opportunity, free cash flow, size, retained earnings to book value of equity and profit as the measurement level of agency costs present in firms for testing the impact of agency cost on dividend policy Specifically, the free cash flow has negative influences but leverage and profitability variables appear to have positive influences on dividend payouts of Jordan firms. 241

9 References - Adaoglu, C., Instability in the Dividend Policy of the Istanbul Stock Exchange (ISE) Corporations: Evidence from an Emerging Market, Emerging Markets Review 1, pp ap Gwilym, O., J. Seaton and S. Thomas, 2004, Dividends Aren t Disappearing: Evidence from the UK., Working Paper, University of Southampton - Aivazian, V. L. Booth, and S. Cleary, Do emerging market firms follow different dividend policies from U.S. firms, The Journal of Financial Research 26, pp Amidu M. and Abor J., Determinants of dividend payout ratios in Ghana, The Journal of Risk Finance Vol. 7, pp Allen, Franklin and Roni Michaely, 1994, Dividend Policy, working paper, Wharton School. - Black, F. (1976). The Dividend Puzzle. Journal of Portfolio Management 2, 5-8, doi: /jpm , - Baker.Kent. H. Saudi s, Dutta. Gandhi. D, The perception of dividend by Canadian managers: new evidence, International Journal of Managerial Finance vol.3. - Chen, C. R., and Steiner, T. L., Managerial ownership and agency conflicts:anonlinear simultaneous equation analysis of managerial ownership, risk taking, debt policy and dividend policy, Financial Review 34, pp DeAngelo, Harry, Linda DeAngelo, René M. Stulz, Dividend Policy, Agency Costs, and Earned Equity, Financial Economics Working Paper, No Denis, D.J. & Osobov, I. (2008). Why Do Firms Pay Dividends? International Evidence on the Determinants of Dividend Policy. Journal of Financial Economics 89, 62-82, doi: /j.jfineco , - Easterbrook, F., Two Agency Cost Explanations of Dividends, American Economic Review Vol. 74, pp Eddy, A. and B. Seifert, Firm Size and Dividend Announcements, Journal of Financial Research 11, pp Eriotis. Nikolaos, The Effect of distribution Earnings and size of the firm to its dividend policy, International and economics Journal - Fama, F.E. & French, K.R. (2001). Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay? Journal of Financial Economics 60, 3-43, doi: /s x(01) , - Fama, E.F. and K.R. French, Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?, Journal of Financial Economics Vol. 60, pp Fama, E.F. and Jensen, Michael, Agency Problem and Residual Claims, Journal of Law and Economics Vol. 26, pp Huang, Samuel G. H. and Song, Frank M., The Determinants of Capital Structure: Evidence from China, HIEBS (Hong Kong Institute of Economics and Business Strategy) Working Paper, pp

10 - Hoberg, G., Prabhala, R., Disappearing Dividends: The Importance of Idiosyncratic Risk and the Irrelevance of Catering, Unpublished Working Paper. - Holder, M., F. Langrehr, and J. Hexter, Dividend Policy Determinants: An Investigation of the Influences of Stakeholder Theory, Financial Management 27, pp Harris, Milton, and Artur Raviv, Capital Structure and the Informational Role of Debt, Journal of Finance Vol. 45, pp Jensen, M., D. Solberg, and T. Zorn, Simultaneous Determination of Insider Ownership, Debt and Dividend Policies, Journal of Financial and Quantitative Analysis 27, pp Jensen, Michael, Agency Costs of Free Cash Flow, Corporate Finance, and the Market For Takeovers, American Economic Review 76, 1986, pp Jensen, M. C., Agency Costs of Free Cash Flow, Coporate Finance and Takeovers, American Economic Review Vol. 76, pp Jagannathan, M., Stephens, C., Weisbach, M., Financial Flexibility and the Choice between Dividends and Stock Repurchases, Journal of Financial Economics Vol. 57, pp LaPorta, R., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R.W. (2000). Agency Problems and Dividend Policies around the World. Journal of Finance 55, 1-33, doi: / , - Manos, R., Dividend Policy and Agency Theory: Evidence on Indian Firms, Working Paper, Institute for Development Policy and Management, University of Manchester Miller, Merton and Franco Modigliani, Dividend Policy, Growth and the Valuation of Shares, Journal of Business 34, 1961, pp Mollah, S., K. Keasey, and H. Short, 2002, The Influence of Agency Costs on Dividend Policy in an Emerging Market: Evidence from the Dhaka Stock Exchange, Working Paper - Nacelur. B. S, Goad s, Beelines, On the determinants and Dynamics of Dividend policy, Journal of international review of finance - Redding, L., 1997, Firm Size and Dividend Payouts., Journal of Financial Intermediation 6, Rajan, R. G. and Zingales, Luigi, What Do We Know about Capital Structure? Some Evidence from International Data, Journal of Finance Vol. 50, No. 5, pp StataCorp Stata Statistical Software: Release 8.0, (Stata Corporation, College Station, Texas - Travlos, N., V. Murinde, and K. Naser, Dividend Policy of Companies Listed on Young Stock Exchanges: Evidence from the Muscat Stock Exchange, Working Paper 243