Asian Research Consortium

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1 Asian Research Consortium Asian Journal of Research in Banking and Finance Vol. 4, No. 12, December 2014, pp ISSN Asian Journal of Research in of Research in and Banking and Finance Effect of Free Cash Flow Agency Problem on Ohlson Model's in Firm Life-Cycle Framework: Evidence from Tehran Stock Exchange (TSE) Kazem Goodarzi a, Ali Jamshidi b a, b M.A. in Accounting, Department of Accounting, NourabadMamasani Branch, Islamic Azad University, NourabadMamasani, Iran DOI NUMBER / Abstract The main objective of this study was to the effect of free cash flow agency problem on Ohlson model's in firm Life-Cycle Framework. Free cash flow agency problems are effective in the valuation of the firm by influencing the earning reliability, which also affects the book value per share indirectly. In this study we review the effects of free cash flow agency problems on the value relevance of earning per share and the book value per share stock price. Hypotheses once for all firms and once with the consideration of the life cycle are also studied. According to the considered situations for selecting the samples, 107 firms were chosen during the period of 2005 to 2013.The several statistical tools have been used in this research. Firstly, multi regressions were used for testing the study hypotheses. Lastly, Adjusted-R2 and Test Z- Wong was used to for the study variables. First, the descriptive statistical tools for the main variables are shown; then the main statistical problems in these regression models are discussed; and lastly the regression models statistical results are provided. Research findings indicate that earning per share has a significant and positive relationship with book value per share stock price, and free cash flow agency problems will result in the reduction of the relevance of earning per share and book value per share stock price. The results are now in various stages of the life cycle (growth, maturity and decline) has been confirmed. The results are firm in various stages of the life cycle are significantly different from each other. Also in stages of decline, the highest agency problems hold to maturity and growth. Free cash flow agency problems will result in the reduction of the relevance of earning per share and book value per share stock price. Keywords: Firm Life Cycle, Free Cash Flow, Agency Problems, Earning and Book Value per Share. 60

2 1. Introduction In this study it is argued that It features the company can be divided into homogenous groups and generally are indifferent stages of the life cycle of the company. Therefore, the aim of this study is that it uses the concept of corporate life cycle and the life cycle of the relationship between the company and the amount of intangible assets, to fill the gap in research. The first method proposed by Anthony and Ramesh (1992), companies based on various stages of the life cycle of the company are divided in to three categories: the growth, maturity and decline. The concept of life cycle in recent decades is a term known in the accounting literature. All living organisms, including plants, animals and humans may follow all the curves life or the life cycle. These beings are born, grow, to reach old age and eventually die. The life cycle theory assumes that firms and enterprises, like all living creatures that are born, grow and die life or the life cycle of the curve are the. Some researchers in the field, accounting for three stages of growth, maturity and decline explanation to describe the life companies have the characteristics of each of these steps for each course will have different capital structures. Which are briefly described below: 1. Stage of growth: the growth stage companies with significant products (significantly) and then the rate of increase in the markets hares of competitors in the market is constant and a constant stage of growth is (Black, 1998).The steady growth due to lack of financial resources needed to invest more. At this stage, new technologies and new products have gradually evolves gradually to be accepted by the market and the increase in sales due to reduced corporate risk. At this stage, negative cash flows and the company have high growth opportunities, so firms have less debt than firms are in the stage of maturity. 2. Stage of maturity: In this Stage Company with a history of more stable and have high profitability and cash flows from operations and financial management functions successfully. Stock market and the interest rate is fixed at this stage (Black, 1998). The next stage is divided into two categories: early puberty and adulthood. Precocious puberty due to the efficient conduct of operations associated with the growth and profit of the best stages of the life cycle is considered. The next stage of evolution and the formation of professional corporations and other applications is the most important phase of the life cycle (Black, 1998). In this stage, the company has a history longer than the growth stage and Terms of financial performance that is better than the other stages and growth opportunities are less. So, we can profit from additional debt financing to use. But the one hand, the company has high liquidity; preferably Companies should try to use more domestic resources to finance that. Jensen (1986) identifies free cash flows (FCF) as one of the sources of agency problems. He defines FCF as cash flow in excess of that required in financing all projects that have positive net present values when discounted at the relevant cost of capital. However, FCF causes potential conflict of interest between managers and shareholders. Shareholders wish FCF to be paid as dividend, managers tend to invest it in new projects. Managers might think that payout to shareholders would reduce the resources under their control, thereby reducing power (Asma Khan et al, 2012). 61

3 3. Stages of decline: At this stage the company is facing ruin and destruction, and is unable to generate sufficient resources for their survival and a sliding toward bankruptcy is complete. Them rather than by market forces to continue their activities by artificial nodal involvement are trying to survive that Eventually be swallowed by competitors (Black, 1998). At this stage, reduced corporate profits and Supply more than demand because financial companies are in critical condition, in such circumstances, they have less debt financing is used. The existence of agency problem for firms with high FCF and low growth opportunity (we denote these two as FCF agency problem onwards) has been well documented (Gul and Tsui,1998 ; Chung et al,2005). Gul and Tsui (1998) tested the hypothesis that there would be a positive association between FCF agency problem and audit fee. Since managers of firms with high FCF agency problem are involved in activities which can affect shareholders wealth, they tend to camouflage the effects of the non-wealthmaximizing investments by accounting manipulation. Therefore, auditors may react by judging those firms as having higher probability of miss statements and require bigger effort. As a result, auditors would impose higher level of audit fee. A similar explanation also provided by Chung et al. (2005) when they found that managers of firms with high FCF and low growth opportunity have the incentives to camouflage their activities by increasing reported earnings through income-increasing discretionary accruals (Thanatawee, 2011). This FCF agency problem becomes particularly acute for firms with low growth opportunities. In the absence of effective monitoring or disciplinary actions by stakeholders, managers of firms with positive FCF but low growth opportunities (hereafter suspect firms) are more likely to invest in marginal or even negative net present value (hereafter NPV) projects to maximize their private benefits. This valuedestroying investment activity eventually results in lower stock prices, and may trigger shareholder actions to remove directors and senior executives (Jensen 1986). Rational managers may mask such activities by deploying accounting discretion to increase reported earnings. Chung, Firth and Kim (2005) support this proposition by reporting that managers of suspect firms tend to use income-increasing discretionary accruals to increase reported earnings. Evidence of managerial opportunism regarding FCF is also reported by Gul and Tsui (1998) and Gul (2001). This study contributes to literature in which it integrates the studies on Effect of of free cash flow agency problem on Ohlson model's in firm Life-Cycle Framework. In other to, We investigation that effect of free cash flow agency problem relation between EPS and BV with stock price in stages of growth, maturity and decline in firm Life-Cycle is different. 2. Literature Review DeAngelo et al (2006) test the life-cycle theory by examining whether the probability to pay dividends is related to the earned/contributed capital mix, as measured by retained earnings to total equity (RE/TE) or retained earnings to total assets (RE/TA). Typically, firms with low RE/TE (RE/TA) tend to be in the growth stage and reliant on external capital while firms with high RE/TE (RE/TA) tend to be more mature with high accumulated profits, thus making them good candidates to pay dividends. Consistent with the life-cycle theory, their evidence indicates that the earned/contributed capital mix has a positively 62

4 significant relation with the probability that a firm pays dividends, controlling for firm size, current and lagged profitability, growth, total equity, cash balances, and dividend history. This relation also holds for the probability that a firm initiates or omits dividends. In addition, DeAngelo et al. document a substantial increase in firms with negative retained earnings from 11.8% in 1978 to 50.2% in 2002, a finding that further explains why U.S. firms have lower propensity to pay dividends during such period as documented by Fama and French (2001). Rahman and Saleh (2009) examined the effects of free cash flow agency problems on value relevance of earnings per share and book value per share stock price in the period of 2002 to The results showed that there was a significant and positive relationship between the earning per share and book value per share stock price. But the managers of the companies that had free cash flow agency problems reduced the value relevance of earnings per share and book value per share stock price by manipulating earnings (earnings management). In other words, the free cash flow agency problems resulted in the decrease of explanatory power of earning per share and book value per share for predicting the stock price. Ahangari and Shakeri (2009) examined the effect of earnings management on earnings value relevance and book value associated with the stock market value of the companies listed in Tehran Stock Exchange. This research was conducted in the period of The research showed that the weak capability of earnings reduces the reliability of earnings. The earnings management reduced the value relevance of earnings with stock price and increased the value relevance of book value stock price. Alfaraih and Faisal (2010) examined the relationship between earnings accounting and book value per share stock price and the return of stock of the companies listed in Kuwait Stock market in the period To test their hypothesis, the price and return models were used. The results of these two models have shown that earnings and book value jointly and singly have a significant and positive relationship with their stock prices and returns. Thanatawee (2011) Life-Cycle Theory and Free Cash Flow Hypothesis: Evidence from Dividend Policy in Thailand the findings provide much support for the free cash flow and life-cycle hypotheses. Further, it is found that financial leverage is positively related to dividend payouts, a finding which casts doubt whether Thai firms rely on debt to pay dividends. Talebnia et al. (2012) examined Effect of Free Cash Flow Agency Problem on the Value Relevance of Earning per Share and Book Value per Share with Stock Price in the Chemical and Medical Industries. Research findings indicate that earning per share has a significant and positive relationship with book value per share stock price, and free cash flow agency problems will result in the reduction of the relevance of earning per share and book value per share stock price. Salehi and et al (2013) examined moderating effect on the relationship between a companies s life cycle and the relevance of accounting practices intangible assets.the overall results show that the different life cycle stages of company maturity, the strongest influence on the amount of intangible assets is concerned. Our results also suggest that the relevance of intangible assets during the period prior to the implementation of the standard is the standard. 63

5 3. Methodology The present study, based on its objectives, is a practical research and its results can be used by managers, investors and in general all users. Methodologically speaking, this is a correlation research which examines the Effect of Free Cash Flow Agency Problem on Ohlson's Price model's in firm life cycle at firms which were accepted in Tehran stock market. This study aims to examine the relationship between the variables, it uses a correlation method to test the assumptions of multi variable regression, which according to assumptions the following models will be presented and tested. This study used Ohlson's (1995) price model to examine the value-relevance of earnings and book value. 4. Research Hypotheses : There is a positive relation between price per share and EPS in firm Life-Cycle. : The free cash flow agency problem reduces value-relevance price per share and EPS in firm Life- Cycle. : There is a positive relation between price per share and book value per share in firm Life-Cycle. : The free cash flow agency problem reduces value-relevance price per share and book value per share in firm Life-Cycle. : Effect of Free Cash Flow Agency Problem on Ohlson model'sin stages of growth, maturity and decline are significantly different from together. 5. Research Variables and Their Measurement Independent variables in this study are FCF agency problem, book value per share and earning per share and the dependent variable is the price per share. The following is how to measure them: Table 1: Variables Measurement Stock Price Earning per Share Book value of Equity Free Cash flow Growth Opportunity P EPS BV FCF MTB Market value of Equity at year's end Earning Per Share at year's end Book value of Equity at year's end (Operating Cash Flow -NetInvestment infixed Assets)/ Assets Total Ratio Market value to book value 64

6 5.1. Corporate Life Cycle Analysis Methodology Anthony and Ramesh (1992) in their study of the stages of the life cycle for each of the four variables: sales growth, capital expenditure, dividends and age of participants was used. In this study, to the company's growth, maturity and decline using the variables of the Park and chen (2006) is as follows: 1-First, the value of each variable sales growth, dividends and capital expenditures ratio is calculated for each year of age. 2-Yearbased on each of the four variables using statistical quintile in each industry can be divided into five categories that With regard to exposure quintile (class) desired, Table (1) scores are between1 and 5. 3-Afterlosingthecompositescorefor each year, which is due to the following conditions of growth, maturity and decline categorized as: A. If the total scoreisbetween16 and 20isin the growth stage. B. Voice of the total scoreisbetween9 and 15arein the mature stage. C. If the total is between 4 to 8are in decline stage. Table 2: Method to measure life cycle Quintile (DPR) (CE) (SG) (AGE) First Second Third Fourth Fifth How to calculate these variables are as follows: SG it = [1-SALEit/SALEit-1]*100 DPR = (DPS it / EPS it)*100 CE it = (additions (reductions) in fixed assets during the period/market Value)*100 Free Cash Flow Agency Problem is identified when the free cash flow is above the sample median for the year and the price to book ratio is below the sample median for the year. 65

7 This study also investigates the effect of FCF agency problem on the value relevance of earnings and book value by using Ohlson s model, As follows: = Hypotheses 1 stated that in hence earning are positively related to share price and Hypotheses 2 stated that FCF agency problem reduce value-relevance earning per share. The hypotheses are tested using below model: + + The above model of stages of growth, maturity and decline is also examined. FCFAP: it is a dummy variable set equal to 1 for FCF agency problem firms (firms with high free cash flows but low price-to-book value ratio) and 0 for no-fcf agency problem firms. FCFAP it *EPS it : Interaction between FCFAP it and EPS it FCFAP it *BV it : Interaction between FCFAP it and In study the effects of free cash flow agency problems (FCFAP it ) on value relevance of earnings per share and book value per share, a Dummy variable (free cash flow agency problems) used. If is positive in both models, indicative a positive relationship between book value and earnings per share of stock price, of course when there are no agency problems. But, the slope shows the value relevance of FCF agency problem. The β 4,5 shows the impact of FCF agency problem on the value relevance of book value and earnings per share respectively. But if β 4,5 is negative in both models, the second and fourth hypotheses are confirmed. 6. Statistical Population, Sampling Method and Data Collection Method The statistical population in this study includes the listed firms in Tehran Stock Exchange in the period of Existence of some heterogeneousness among the listed firms in Tehran Stock Exchange led to consider some special conditions for selection of studied companies as follows: a. Firms should have been accepted in TSE since b. Fiscal periods of these firms should be leading to the end of the year. c. Firms should not have changed their year-ends. d. Firms should not be in a financial or investing industry. e. There is a need for availability of data. 66

8 Upon above conditions, we select 107 firms. We collect data from database of Tehran Stock Exchange and RahavardeNovin software. Then we analyze these data by SPSS and EViews software. 6. Hypotheses Test Results Table 3: Results from hypotheses test + + Variable Total Model growth Model maturity Model decline Model Constant R Adj- R F- Test

9 In Table3, due to the significant and positive coefficient of EPS and BV at different stages of the life cycle (growth, maturity and decline), first and third research hypotheses were confirmed. In the above table, the coefficients negative for β4and β5we conclude that the agency problems of free cash flow to reduce of relation between EPS and BV stock with stock price at different stages of the life cycle (growth, maturity and decline). The following table, impact of the cost agency of free cash flow is shown in various stages of the life cycle. According to reduction of agency problems (FCFAP*EPS and FCFAP*BV) Hypotheses 3 and 4 are confirmed. Table 4: Impact of FCF on the relationship between EPS and BV with P in the growth, maturity and decline. Model EPS FCFAP*EPS EPS+ FCFAP*EPS BV FCFAP*BV BV+FCFAP*BV Total Growth Maturity Decline In order to investigate third and fourth hypotheses of model (2) is used and the results are shown in table (4). To investigate effect of free cash flow agency problem on Ohlson model's in stages of growth, maturity and decline are significantly different from together, we use Z-test to compared models at stages of growth, maturity and decline explains. Also test variables regression model coefficients (T-test) is that the coefficients are significant. Book value per share with the stock price has a direct and positive effect relationship the book value of per share has information content in relation to the stock price. As a result, hypothesis 3 is supported. The fourth hypothesis testing: To evaluate the impact of the agency problems of free cash flow on the relationship between book value and price per share, by comparing the coefficients (2.277)and ( ), we reached the conclusion that agency problems of free cash flow, causing a reduction in relationship between book value and the price per share to amount 1.94( ), Because coefficients negative. Therefore, Agency problems of free cash flow, reduced relationship between the book value and price per share is positive and significant. Thus, Hypothesis 4is accepted. By comparing models at different stages of growth with maturity, growth with decline and decline with maturity of the results indicated significant difference between the models. Then, by comparing the coefficient of determination in various stages life cycle of firms in decline stages of maturity and growth 68

10 of the agency problems of free cash flow further reduces the relationship between the book value and earnings per share of the stock prices, Because the coefficient of determination of decline stage (0.806) is the larger than maturity (0.646) and growth (0.500). Thus Hypothesis 5 is accepted. Table 5: Results from Z test Model Growth Model Growth Model Maturity and Maturity and Decline and Decline Z-stat p-value Suggestions This study investigates the effect of FCF agency problem on the value relevance of earnings and book value by using Ohlson s model firm life-cycle Framework. Research findings indicate that EPS and BV has a significant and positive relationship with stock price, and free cash flow agency problems will result in the reduction of the relevance of earning per share and book value per share stock price. The results are now in various stages of the life cycle (growth, maturity and decline) has been confirmed. Results indicated firms in various stages of the life cycle are significantly different from each other. Also in stages of decline, the highest agency problems hold to maturity and growth. Free cash flow agency problems will reduction of the relevance of EPS and BV with stock price. Free cash flow agency problems associated BV and EPS with stock prices is positive and significant relationship at all stages of the life cycle (growth, maturity and decline) decreases. So we can conclude that effect agency problems of free cash flow on relationship between BV and EPS with prices at different in stages life-cycle. There for, by comparing the coefficient of determination in various stages life cycle of firms in decline stages of maturity and growth of the agency problems of free cash flow further reduces the relationship between the book value and earnings per share of the stock prices This is consistent to prior studies such as Jaggi and Gul (2000), Whelan (2004), Ahangari and Shakeri (2009), Rahman and Saleh (2009), Khodadadi et al (2010) and Talebnia et al (2012). References Ahangari, A. and Shakeri, L. (2009). Study of the effect of earning management on value relevance of earning and book value with stock market value of companies listed in Tehran Stock Exchange Market, Financial Accounting Quarterly, first year, p Alfaraih, M. and Faisal, F. (2010). The usefulness of earnings and book value for equity valuation to kuwait stock exchange participants, the international business and economics research journal, Vol 10, pp:

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