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European Journal of Economics, Finance and Administrative Sciences

ISSN 1450-2275 Issue 33 (2011) EuroJournals, Inc. 2011

http://www.eurojournals.com

Agency Costs of Free Cash Flow, Dividend Policy, and

Leverage of Firms in Indonesia

Siti Rahmi Utami

Maastricht School of Management Endepolsdomein 150

6229 EP Maastricht The Netherlands

E-mail: [email protected]

Eno L. InangaMaastricht School of Management Endepolsdomein 150

6229 EP Maastricht The Netherlands

Tel: +31 43 387 0808

E-mail: [email protected]

Abstract

The objectives of the study are to examine how firms in Indonesia, with substantial free

cash flow, control agency cost of free cash flows, and test the effect of agency costs ondividend and leverage. It also tests the difference in agency costs between companies that

pay and companies that do not pay regular dividends to their shareholders. In testing the

relevant hypotheses, we use agency costs variables. Profit, growth, risk, size, and free cashflow, are used to measure for the level of agency costs of the firms, while leverage and

dividends are used as proxies for financial policies to address free cash flow problems. By

using regression analysis, and collecting the data of firms in Indonesia over the period1994-2007, our results show that there is a negative insignificant effect of free cash flow ondividend, but imply positive significant effect of free cash flow on leverage. Regression

results also show negative significant effect of free cash flow on dividend, negative

insignificant effect of growth on dividend, but positive significant effect of leverage ondividend. Meanwhile, we find positive but not statistically significant effect of profit,

firms size, and risk on dividend. For firms that have 5-years dividend payment period, we

find positive significant effect of free cash flow on dividends while for firms that have lessthan 5-years dividend payment period, result shows negative significant effect. Finally, the

effect of agency cost of free cash flow on leverage for both categories of firms is positive

but not significant.

Keywords: Agency Costs, Free Cash Flow, Dividend, Leverage

1. IntroductionThe free cash flow hypothesis of Easterbrook (1984) and Jensen (1986) states that companies with

substantial free cash flow always tend to face conflicts of interest between stockholders and managers.

Managers, once they have satisfied all the obligations contracted by the company with funds generatedby operations, can use the remaining flows from the treasury for their own benefit instead of the

interest of shareholders (Jensen, 1986).A higher relative dividend payout or a higher effective dividend yield is expected to minimise

agency costs, as dividends lower the level of available liquidity which increases the potential default


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8 European Journal of Economics, Finance And Administrative Sciences - Issue 33 (2011)

risk of firms. Hence, the higher are dividends relative to earnings, the stronger is the focus likely to be

on future earnings performance as a means of maintaining the current dividend payout level. Leverage

is also suggested as having a positive incentive effect on firm management resulting from the adverseconsequences associated with defaulting on debt obligations. The use of external debt finance will also

result in the firm likely being subjected to additional outside monitoring by debt providers, which have

similar incentives to major institutional investors or external stockholders in relation to protecting their

investment interests. As such, increasing leverage use should reduce the extent of agency costs inherent

in a firms operating structure.Prior research has focused primarily on ownership structure and particularly the degree of

separation of control and ownership claims, as a key determinant of agency costs. However, agencyreduction mechanisms that have been suggested in prior literature include the employment of debt

financing (such as Agrawal and Knoeber, 1996; Fleming, Heaney, and McCosker, 2005) and dividend

policy (for instance, Holder et al., 1998; La Porta et al., 2000; Mollah et al., 2002; DeAngelo et al.,2004; Amidu and Abor, 2006; and Baker et al., 2007) remain likely candidates as the agency control

mechanisms.

Therefore, in this research, we test the role of leverage and dividend policy as agency controlmechanisms of free cash flow problem, and we also measure profit, growth, risk, size, leverage, and

free cash flow, for the measurement of level of agency costs present in firms for testing the impact of

agency cost on dividend payment.The rest of this paper is divided into 5 sections. Section 2 reviews the previous research. In

section 3 we formulate hypotheses on the subject matter of the study. Section 4 explains research

methodology to test a number of hypotheses relating to our research focus. Section 5 analyses and

discusses the results of hypotheses testing. Section 6 is the concluding section.

2. Previous ResearchDividend is substitute mechanism for reducing the agency costs of free cash flow, while debt serves as

another mechanism for reducing the agency costs of free cash flow. Many previous research have beendone regarding dividend and debt to reduce free cash flow agency problems.

Agency models (Easterbrook, 1984; Jensen, 1986; Myers, 2000) assert that dividend paymentsaddress conflicts of interest between corporate insiders (such as managers and controllingshareholders) and outside (minority) shareholders. Corporate insiders can pursue company policies that

benefit themselves at the expense of minority shareholders, for example, through the diversion of

corporate assets to themselves, excessive salaries (La Porta et al., 2000) or investments in low-returnprojects (Jensen, 1986). These agency problems are particularly severe when a firm generatessubstantial amounts of free cash flow (Jensen, 1986). Dividend payments could mitigate these

problems by removing corporate resources away from the control of corporate insiders. Jensen (1986)

persuasively argues that debt is an effective substitute mechanism for dividend in this respect.Rojeff (1982) and Easterbrook (1984) argue that the payment of dividends, by causing firms to

visit capital markets more frequently for financing needs, brings them under greater scrutiny of capital

markets. By paying dividends, the firm makes a quasi-fixed commitment to shareholders to pay outcash at regular intervals. This commitment reduces the discretionary resources under the control of

managers and subjects them to greater monitoring by capital markets that occurs when the firm seeks

new capital. They conclude from their study that management can minimize equity agency costs bypaying dividends, and forcing the firm to resort to the capital markets for additional financing.

A study by La Porta, Lopez-de-Silanes, Shleifer and Vishny (1999), conclude that in a situation

of significant agency problems between corporate insiders and outsiders, dividend payments can play a

useful role. By paying dividends, insiders return corporate earnings to investors and hence are nolonger capable of using these earnings to benefit themselves. Dividends are better than retained

earnings because the latter might never materialize as future dividends. In addition, the payment of

dividends exposes companies to the possible need to go to the capital markets in the future to raise


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external funds, and hence gives outside investors an opportunity to exercise some control over the

insiders at that time (Easterbrook, 1984).

La Porta et al. (2000) discuss two alternative agency models. Their first model posits that abetter legal protection of the minority shareholders leads to more dividends being extracted from the

firm. Their alternative model postulates that dividends are a substitute mechanism for legal protection.

Dividends are then paid out when firms try to establish a reputation for good treatment of shareholders

and signal that expropriation does not have to be a concern. Hence, dividend policy acts as a corporate

monitoring mechanism.The research of DeAngelo, DeAngelo and Stulz (2004) use a sample of 25 industrial firms of

NYSE, NASDAQ, and AMEX that distributed the largest total real dividends over the years 1950-2002. Their study results show that dividend payments prevented significant agency problems. This

logic suggests that firms with relatively high amounts of retained earnings are especially likely to pay

dividends over time. Overall, their evidence supports the hypothesis that firms tend to pay dividends inorder to mitigate agency costs associated with high cash and low debt capital structures that would

eventually result if they did not pay dividends. DeAngelo et al. (2004) document that the dividend

payments prevent significant agency problems since the retention of the earnings give the managerscommand over an additional access to better investment opportunities and without any monitoring.

Hufft and Dufrene (1996) find that paying dividends decreases retained earnings formerly

allocated for expansion, and this inevitably requires the firm to seek external financing from the capitalmarkets. Thus, management can optimally select leverage and dividends to control agency costs.According to Zwiebel (1996) empire-building managers are expected to voluntarily pay out dividends

as a protection against disciplinary sanctions by outsiders. Hu and Kumar (2004) imply that managers

who are more likely to take sub-optimal decisions choose higher payout levels. So do managers whocan be disciplined by outsiders at relatively low costs. Jensen, Solberg and Zorm (1992) obtain the

empirical evidence that the dividends paid by the company are negatively related to its financial

leverage. These results are consistent with the explanation of the dividend policy of companiesproposed in the hypothesis of free cash flow of Jensen (1986).

Meanwhile, management can also optimally select leverage to control agency costs. By issuing

debt instead of equity, managers give bondholders the right to take the firm into bankruptcy court if

managers do not maintain their promise to make the interest and principal payments. Thus, likedividends, debt reduces the agency costs of free cash flow by reducing the discretionary resources

under managers control. This substitutability between debt and dividends as alternative mechanisms

for reducing the agency costs of free cash flow implies that firms that use low debt ratios will tend tofollow a policy of high-dividend payout.

According to Agrawal and Knoeber (1996), debt financing is often used either as an alternative

or complementary control mechanism for reducing agency costs of a firm. Fleming, Heaney andMcCosker (2005) outline a number of benefits associated with the use of debt financing in controlling

agency costs. Grossman and Hart (1982) suggest that short term debt can align managerial incentive

with that of shareholders since bankruptcy is costly for management. They also support the agency

theory and argue that financial leverage can reduce agency costs by increasing the possibility of

bankruptcy. Grossman and Hart (1982) and Williams (1987), however, advanced the argument thatgreater financial leverage may affect managers and reduce agency costs through the threat of

liquidation, which causes personal losses to managers of salaries, reputation, perquisites, and,according to Jensen (1986), through pressure to generate cash flow to pay interest expenses.

Myers (1977) explains that higher leverage can mitigate conflicts between shareholders and

managers concerning the choice of investment. Since debt has to be paid back in cash, the amount offree cash flow that could be diverted by the manager is reduced by debt repayment. Debt thus serves as

a mechanism to discipline corporate managers and prevent them from maximizing their private gains

by lavish perquisites, plush offices, and empire building through sub-optimal investment decisions(Jensen and Meckling, 1986). Agrawall and Jayaraman (1994) comparing the dividend policy of

companies in debt and of companies not in debt and, companies with a high degree of participation of


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shareholders in their capital and that of companies with low participation. Their results show that

companies in debt and with low presence of managers among their shareholders have higher target

payout ratios.There are many previous research findings regarding risk, grow, size, profit, and free cash flow

for the level of agency costs present in firms to test the impact of agency cost on dividend payment

ratios. Regarding free cash flow, according to Jensen (1986), free cash flow is defined as cash flow in

excess of funds required for all projects with positive net present value (NPV). He showed that

increasing free cash flow enhances agency conflicts between managerial interest and outsideshareholder, which causes a decrease in the company's performance. While the desire of shareholders

for their managers to maximize their shares value, managers may have different interests and prefer togain benefits for themselves. This theory has been supported by Jensen et al. (1992) and Smith and

Watts (1992).

Studies result regarding relationship between dividend payout and free cash flow are thefollowing. 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 higherfree 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

Abor (2006) find dividend payout policy decision of listed firms in Ghana Stock Exchange isinfluenced by cash flow position of the firms. DeAngelo et al. (2004) document highly significantassociation between the decision to pay dividends and the ratio of earned equity to total equity

controlling for cash balance.

Regarding leverage, a number of studies have concluded that the level of financial leveragenegatively influenced dividend policy (for instance, Jensen et al., 1992; Agrawal and Jayaraman, 1994;

Crutchley and Hansen, 1989; Faccio et al., 2001; and Gugler and Yurtoglu, 2003). Their study

concluded that a highly levered company tries to maintain internal cash flow to meet the task, ratherthan distribute the available cash to shareholders and protect their creditors. DeAngelo et al. (2004)

found highly significant association between the decision to pay dividends and the ratio of earned

equity to total equity controlling for leverage.

Some research findings regarding relationship between dividend payout and growthopportunities are as follow. Dividends were found to be higher in firms with slow growth

opportunities, as firms with high-growth opportunities have lower free cash flows, it had been

concluded by Rozeff (1982), Jensen et al. (1992), Dempsey and Laber (1992), Alli et al. (1993), andHolder et al. (1998).

A conclusion for the relationship between growth opportunities and dividend policy was that a

firm tended to use internal funding sources to finance investment projects if it had large growthopportunities and large investment projects. Such a firm chooses to cut, or pay fewer dividends, to

reduce its dependence on costly external financing. However, firms with slow growth and fewer

investment opportunities pay higher dividends to prevent managers from over-investing company cash.

Dividend here would play an incentive role, by removing resources from the firm and decreasing the

agency costs of free cash flows, it implied by Jensen (1986), and Lang and Litzenberger (1989).Murrali and Welch (1989), Titman and Wessels (1988), and Gavers and Gavers (1993) revealed

that growth firms, as compared to non-growth firms, exhibited a lower debt to reduce their dependenceon external financing, which is costly. La Porta et al. (2000) concluded that in countries with high legal

protection for shareholders, the fast-growth firms paid lower dividends as the shareholders were legally

protected, allowing them to wait to receive their dividends when the investment opportunities weregood. Whereas in countries with low legal protection, firms kept the dividend payout high, in order to

develop and maintain a strong reputation, eventhough when they had better investment opportunities.

Baker et al. (2007) finds that Canadian dividend paying firms are significantly having somegrowth opportunities. Amidu and Abor (2006) find dividend payout policy decision of listed firms in

Ghana Stock Exchange is influenced by growth scenario and investment opportunities of the firms. In


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investigating the determinants of dividend policy of Tunisian stock Exchange, Naceur et al. (2006) find

that the firms with fast growth distribute the larger dividends so as attract to investors. DeAngelo et al.

(2004) document highly significant association between the decision to pay dividends and the ratio ofearned equity to total equity controlling for growth.

Several research which tested relationship between dividend payout and profitability are the

following. According to Jensen et al. (1992), Han et al. (1999), and Fama and French (2000),

profitability of a company is positive and significant explanatory variable dividend policy. Wang et al.

(2002) compare dividend policies of Chinese and UK listed companies, and found that the former tendto choose the higher dividend payout ratio, than the latter. In addition, UK firms have a clear dividend

policy which increases the annual dividend and all firms pay dividends in cash. In contrast, Chinesefirms dividend payment is unstable and its dividend ratio is deeply based on their company's earning

for the same year, not on any other factors.

The finding of Adaolu (2000) states that the main determinant in the amount of cash dividendin 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 ofshareholders, and related that for countries with low quality of shareholder protection laws. Their

conclusion is that shareholders will take whatever they can obtain cash dividends from company

profits, in which the dividend is deemed unstable.Baker et al. (2007) report that Canadian dividend paying firms are significantly more profitable.

Amidu and Abor (2006) find dividend payout policy decision of listed firms in Ghana Stock Exchange

is influenced by profitability of the firms. Eriotis (2005) reports that the Greek firms distribute

dividend each year according to their target payout ratio, which is determined by distributed earningsof 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. DeAngelo et al. (2004) documenthighly significant association between the decision to pay dividends and the ratio of earned equity to

total equity controlling for profitability.

The empirical analysis by Adaoglu (2000) shows that the firms listed on Istanbul Stock

Exchange follow unstable cash dividend policy and the main factor for determining the amount ofdividend is earning of the firms. Fama and French (2001) conclude that the probability that a firm pays

dividends is positively related to profitability and size and negatively related to growth. This suggests

that higher profitability and greater size imply a greater capacity to distribute cash, whereas greatergrowth indicates superior investment opportunities, hence a stronger incentive to retain cash.

Several studies have examined the impact of firm size on the dividend and agency cost

relationship. Jensen and Meckling (1976) argument indicated that agency costs are associated with firmsize. Baker et al. (2007) report that Canadian dividend paying firms are significantly larger. Eriotis

(2005) concludes that the Greek firms distribute dividend each year according to their target payout

ratio, which is determined by size of these 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 size of the firm.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 ownershipdispersion, 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 theneed for external financing leads to an increase in the monitoring of large firms, because of the

existence of creditors.

Lloyd et al. (1985) were considered that firm size an important explanatory variable, as largecompanies are more likely to increase their dividend payouts to decrease agency costs. They were of

the view that for large firms, widely spread ownership has a greater bargaining control, hence, it


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increases agency costs. The positive relationship between dividend payout policy and firm size is

found by Eddy and Seifert (1988), Jensen et al. (1992), Redding (1997), and Fama and French (2000)

which indicated that large firms distribute a higher amount of their net profits as cash dividends, thando small firms.

Holder et al. (1998) revealed that larger firms have better access to capital markets and find it

easier to raise funds at lower costs, allowing them to pay higher dividends to shareholders. This

demonstrates a positive association between dividend payouts and firm size. This positive relationship

is also supported by Manos (2002), Mollah (2002), Travlos et al. (2002). Avazian et al. (2006) studyresult showed that there is a positive and significant relationship between dividend payout and firm

size. This result shows that large-sized firms prefer to pay more dividends.A number of studies regarding relationship between dividend payout and risk have been tested.

For variable of business risk, Jensen et al. (1992) argues that higher systematic risk enhanced the

uncertainty of the direct relationship between current and expected future profit. Therefore, thecompany avoids the commitment to pay dividends, as uncertainty about the increase in revenue.

Bradley, Capozza, and Seguin (1998) show that in firms that distribute free cash flows in the form of

dividends, management can divert fewer funds to projects that are in their best interests rather than inthe interest of their shareholders. Firms with high cash flow volatility are also those with the greatest

potential agency costs.

Rozeff (1982), Chen and Steiner (1999) have been argued that high risk firms have a tendencyto have higher volatility in their cash flow, rather than low-risk firms. As a result, external financingneeds of these companies will raise, encouraging them to decrease dividend payments to keep away

from costly external financing. Mollah (2002) concluded that companies listed on the Dhaka Stock

Exchange pays big dividends, even though they have high beta stock. He then argues that in theemerging stock exchanges, dividends may not be the most proper tool to transmit exact information

about the transaction costs to market.

3. HypothesesBased on previous research, we examine the impact of firms free cash flow agency cost on dividend

payout ratio and leverage, and the influence of free cash flow, leverage, growth, profit, size, and risk asproxies of the level of agency costs on dividend payment ratios by using the following hypotheses:

H1: Firms free cash flow has positive significant effect on dividend payout ratio.

H2: Firms free cash flow has positive significant influence on firms leverage.

H3a: Free cash flow has positive significant effect on dividend payout ratio.

H3b: Dividend payout ratio is negatively affected by leverage.

H3c: The dividend payout is negatively influenced by growth opportunities.

H3d: Firms profitability has positive significant impact on dividend payout ratio.

H3e: Firm size has positive significant effect on dividend payout ratio.

H3f: Dividend payout ratio is negatively influenced by risk.

4. Research Methodology4.1. Data and Sample

Data have been collected from the Indonesia Stock Exchange (IDX) within a period of 1994 to 2007.

Our research population is LQ 45 Index, which comprises 45 companies from various industrialsectors. We have considered using 26 companies from the index as our sample. We divide these firms

become two categories, namely, firms that have 5-years dividend payment period and firms that have

less than 5-years dividend payment period. We found 10 firms had one 5-year dividend payment period

while 16 firms had less than one 5-year dividend payment period among the 26 firms.


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4.2. Hypotheses Testing and Data Analysis

We formulate 5 equations in this study. Equations (1) to (5) will be analyzed using regression analysis

to examine causal relationships between each dependent and independent variables.

4.2.1. Hypotheses 1 and 2The 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.DIV = + *FCF + (1)

LEV = + *FCF + (2)

For model 1, we expect *FCF to be positive, since firms with greater free cash flow have theability to pay higher dividends.

4.2.2. Hypothesis 3

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 = +1*FCF+2*LEV+3*GROW+4*PRFT+5*SIZE+6*RISK+ (3)

4.2.3. The Other TestsWe also test the impact of agency cost of free cash flow on dividend payment and leverage for firms

that have 5-years dividend payment period and firms that have less than 5-years dividend paymentperiod by using the following regression models.

DIV = + *FCF + (4)

LEV = + *FCF + (5)In addition, we analyze descriptive statistic to explore the mean differences between variables

of firms. The objective of this step is to test to what extent the differences in agency costs between

companies that have a 5-years dividend payment period, and firms that have less than 5-years dividend

payment period.

4.3. Measurement of Variables

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 companys 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 (GROW) 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 firms growth assum of total asset and market value of equity minus total equity divided by total asset.

Profitability (PRFT) 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 we calculated it as net profit divided byshareholders equity.


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We measure firm size (SIZE) as a natural logarithm of market capitalisation. 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 (RISK), 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.

5. The Results of Hypotheses Testing5.1. Result of Testing H1 and H2

For hypotheses 1 and 2, dividend and leverage are our dependent variables as their role are to reduce

agency costs of free cash flows, hence, we examine the two hypotheses in this study associated withthe impact of agency cost of free cash flow on dividend payment and leverage.

Table 1: Coefficientsof

Regression of H1 and H2

Model

Unstandardized

Coefficients

Standardized

Coefficients t Sig.Collinearity Statistics

B Std. Error Beta Tolerance VIF

DIV= +*FCF+(Constant) .051 .132 .388 .700

FCF -.156 .084 -.271 -1.860 .069 .705 1.419

LEV= +*FCF+(Constant) -38.713 78.912 -.491 .624

FCF 113.755 49.747 .192 2.287 .024 .931 1.074

Table 1 reports that we find a negative statistically insignificant effect of free cash flow ondividend with -1.860 t-values and 0.069 significance level. It implies that, firms with higher free cash

flow tend to decreased dividend payment to reduce free cash flow problems. This result is inconsistent

with our expectation that *FCF to be positive, since firms with greater free cash flow have the abilityto pay higher dividends. On the other hand, we find a positive and significant effect of free cash flow

on leverage with 2.287 t-values and 0.024 significance level. 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 anddiscretionary 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).

5.2. Result of Testing H3a, H3b, H3c, H3d, H3e, H3f

Risk, leverage, growth, free cash flow, size, and profit have been employed to proxy for the level of

agency costs present in firms. The agency cost measurement employed in this paper is the magnitudeof firm free cash flows, with greater retention of free cash flows within the firm envisaged as being

indicative of potential agency problems and the existence of agency costs. In our hypotheses 3,dividend is dependent variable as it implements to reduce agency costs of free cash flows. Hence, we

investigate the hypotheses 3a-3f in this study regarding the impact of agency cost on dividend

payment.

Table 2: Model Summary of H3

R R-Squared Adjusted R-Squared Durbin-Watson

.552a

.305 .223 1.881

a. Predictors: (Constant), FCF, LEV, GROW, PRFT, SIZE, RISK

b. Dependent Variable: DIV


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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 0.223 with dividend as dependent variable. This means that 22.3% of the reasons why the

firms pay dividend could be explained by the predictors.

Table 3: Coefficients of Regression of H3

Model

Unstandardized

Coefficients

Standardized

Coefficients t Sig.Collinearity Statistics


(Constant) -.048 .132 -.361 .719

FCF -.163 .080 -.284 -2.040 .047 .704 1.421

LEV .028 .011 .362 2.502 .016 .652 1.533

GROW -.044 .032 -.177 -1.364 .178 .813 1.230

PRFT .024 .090 .043 .268 .790 .530 1.885

SIZE .004 .009 .063 .438 .663 .669 1.494

RISK .467 .257 .242 1.814 .076 .768 1.302

Dependent Variable: DIV

DIV = +1*FCF+2*LEV+3*GROW+4*PRFT+5*SIZE+6*RISK+

DIV is dividend payment ratio, FCF is free cash flow, LEV is leverage, GROW is growth opportunities, PRFT is

profitability, SIZE is size, and RISK is risk.

Table 3 presents regression results of agency cost variables on dividend. The regression resultreports a negative statistically significant effect of free cash flow on dividend. The significant value on

this variable is 0.047 with t-value of -2.040. It indicates that firms with high free cash flow tend to

decrease dividend payment. It also shown by the correlation matrix that profitable firms with high freecash flow tend to pay less dividend.

Meanwhile, the regression result shows a positive significant influence of leverage on dividend

with the significant value of 0.016 and 2.502 t-values. It indicates that firms with high leverage tend toincrease dividend payment. The correlation matrix implied that firms with high leverage have

insignificant high free cash flow.

On the other hand, we find a negative but insignificant impact of growth opportunity ondividend with 0.178 level of significance and -1.364 t-values. The interpretation of this result is thatfirms with lower growth opportunities tend to pay dividends in order to reduce agency costs.

Regarding profit and dividend, result shows a positive but not significant effect of profit on

dividend. The significant value on this variable is 0.790 with t-value of 0.268. It indicates that firmswith high profit tend to increase insignificant dividend payments to reduce agency costs of free cash

flow. It is also shown by the correlation matrix which firms that have high profit produce high free

cash flow eventhough not significant.The regression result also shows a positive insignificant effect of size on dividend. The

significant value on this variable is 0.663 and 0.438 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 apositive effect on dividends. As size may also be a proxy for the information that outside investors

have, Fama and Jensen (1983) argue that larger firms tend to provide more information to lenders than

smaller ones. Rajan and Zingales (1995) also argue that larger firms tend to disclose more informationto outside investors than smaller ones. Therefore, larger firms with less asymmetric information

problems should tend to have more equity in their capital structure.

Finally, we also find a positive but not significant influence of risk on dividend with 1.814 t-values and 0.076 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).


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5.3. The Results of the Other Tests

Result of Testing the Effect of Agency Cost of Free Cash Flow on Dividend Payment and

Leverage

The objective of this testing is to examine the effect of agency cost of free cash flow on dividendpayment and leverage for firms with a 5-years dividend payment period and for firms with less than a

5-years dividend payment period.

5.3.1. Free Cash Flow on DividendThe following tables 4 and 5 are reporting the results of testing the effect of agency cost of free cashflow on dividend payment for firms that have a 5-years dividend payment period and firms that have

less than a 5-years dividend payment period.

Table 4: Coefficients of Regression of Free Cash Flow on Dividend

DIV= +*FCF+

Unstandardized

Coefficients

Standardized

Coefficients t Sig.

Collinearity

Statistics


(Constant) .028 .002 11.832 .000

Predictors: (Constant), FCF_5-

years DivPay Period

.051 .014 .471 3.695 .001 1.000 1.000

(Constant) .043 .027 1.582 .128

Predictors: (Constant), FCF_ 0.519).

It also shown by the higher R-squared of 0.017 of firm that have less than 5-years dividendpayment than R-squared of 0.003 of firm with 5-years dividend payment period (in table 7). It indicates

that firms with free cash flow and lower dividend payment have higher leverage than firms with free

cash flow and higher dividend payment.

Table 8: Descriptive Statistics

Firms_5-years

DivPayPeriodSum Mean Std. Deviation

Firms_< 5-years

DivPayPeriodSum Mean Std. Deviation

FCF -3.20 -.0348 .20346 FCF -10.66 -.0839 .23745

LEV 1603.03 15.7160 121.89295 LEV 1307.26 8.8328 85.32508

GROW 100.25 .9829 .40091 GROW 141.22 .9542 .95058

PRFT -217.12 -2.1287 20.18795 PRFT 218.85 1.4787 16.65439

SIZE 1189.36 14.5043 1.70897 SIZE 1562.95 12.8111 1.89837RISK 5.37 .0655 .05509 RISK 9.27 .0813 .08668

Firms_5-year DivPay Period is firms that have one 5-year dividend payment period

Firms_ < 5-year DivPay Period is firms that have less than one 5-year dividend payment period



Table 8 presents firms that have 5-years dividend payment period have higher free cash flow (-0.0348) than firms with less than 5-years dividend payment period (-0.0839), higher leverage (15.7160

> 8.8328), higher growth opportunity (0.9829 > 0.9542), lower profit (-2.1287 < 1.4787), larger size

(14.5043 > 12.8111), and lower risk (0.0655) than firms with less than 5-years dividend paymentperiod (0.0813).


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5.4. Regression Assumptions

Tests carried out before analyzing the regression coefficients of variables. This assumption represents

the ideal condition of reality (Van Horne, 1998). Tests are as follow. Multicollinearity of several sets

of explanatory variables to test whether there is a linear relationship between the population means ofthe response variable and the explanatory variables. The objective of the test is to analyze the

correlation between independent variables. Tolerance values, VIF, and correlation matrix are indicators

to test multicollinearity. Tolerance value and VIF are still good as each values of these tests are from 0to 1 and below 10 (table 1, 3, 4, and 6). From correlation matrix (in appendix), we can indicate that thedividend payout is positively associated with firms leverage and risk while dividend payout is

negatively associated with firms profitability and free cash flow. Risk is positively associated with

firms leverage and growth. Size is positively associated with firms growth and free cash flow.Growth is positively associated with firms size and risk. Free cash flow is negatively associated with

firms risk.

Autocorrelation is an assumption which means that information on some errors do not provideinformation to other errors. Test of autocorrelation will test whether a linear regression model has a

correlation between the errors in period t with an error in period t-1 (before). Durbin Watson (DW) test

statistic testing the correlation between errors. Our test statistic values are between 0 and 4 (table 2, 5,and 7). Heteroscedasticity declare variable Y's equal variation in relation to the value of variable X's.Test of heteroscedasticity aims to interpret whether the regression model has a different residual

variance from an observation to another observation. Graphic shows that the data are not experiencing

heteroscedasticity (in appendix). Finally, if there are two standard deviations from the mean, or someother property of non-normal, then this indicates that there is non-normal distribution assumption. In

this research, the histogram shows the normally graphic pattern of distribution. Graphic normal P-P

plots showed that the dots spread around the diagonal line, and its spread following the diagonal line(in appendix). Thus, the regression models 1-5 that we use already meet the criteria for regression

testing.

6. Summary and Concluding RemarksAfter analyzing the data of firms in Indonesia over the period 1994-2007, by using regression analysis,we find the following results. Hypotheses 1 and 2 investigate the impact of agency cost of free cash

flow on dividend payment and leverage. For hypothesis 1, we find a negative but statistically

insignificant effect of free cash flow on dividend, while for hypothesis 2 we conclude a positive andsignificant effect of free cash flow on leverage.

Hypotheses 3 examine the effect of risk, leverage, growth opportunity, free cash flow, size, and

profit as the measurement level of agency costs present in firms for testing the impact of agency cost

on dividend policy. Regression result shows a negative significant effect of free cash flow on dividend.For the effect of leverage on dividend, regression result shows that there is a positive significant effect

of leverage on dividend. For growth opportunity on dividend, we find a negative but insignificant

effect of growth opportunity on dividend. Meanwhile, result shows a positive but not statisticallysignificant effect of profit, size, and risk on dividend.

Testing results the effect of agency cost of free cash flow on dividend payment are as follow.

For firms that have a 5-years dividend payment period, result shows that there is a positive andstatistically significant effect of free cash flow on dividends while for firms that have less than 5 years

dividend payment period, result shows a negative and significant effect of free cash flow on dividends.

Results of examining the effect of agency cost of free cash flow on leverage ratio for both firms show

that there is positive but not significant effect of free cash flow on leverage.


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APPENDIX

Table 1: Correlations between Variables

DIV FCF LEV GROW PRFT SIZE RISK

DIVPearson Correlation 1 -.331

**.348

**-.153 -.313

**-.200 .259

*

Sig. (2-tailed) .004 .002 .189 .006 .086 .050

FCFPearson Correlation -.331 1 .096 .027 .053 .166 -.212

Sig. (2-tailed) .004 .155 .683 .431 .020 .006

LEVPearson Correlation .348

**.096 1 .017 -.089 .003 .201

**

Sig. (2-tailed) .002 .155 .785 .161 .962 .005

GROWPearson Correlation -.153 .027 .017 1 -.009 .265 .222

Sig. (2-tailed) .189 .683 .785 .884 .000 .002

PRFTPearson Correlation -.313 .053 -.089 -.009 1 -.075 .071

Sig. (2-tailed) .006 .431 .161 .884 .288 .320

SIZE

Pearson Correlation -.200 .166*

.003 .265**

-.075 1 -.206*

Sig. (2-tailed) .086 .020 .962 .000 .288 .013

RISKPearson Correlation .259 -.212 .201 .222 .071 -.206 1

Sig. (2-tailed) .050 .006 .005 .002 .320 .013

**. Correlation is significant at the 0.01 level (2-tailed).

*. Correlation is significant at the 0.05 level (2-tailed).




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Figure 1: Figures of Normal P-P Plot of Regression Standardized Residual and Scatterplot Hypotheses 1 and 2

DIV = +*FCF+

LEV = +*FCF+

Hypothesis 3

DIV = +1*FCF+2*LEV+3*GROW+4*PRFT+5*SIZE+6*RISK+


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The Other Results (For firms that have 5-years dividend payment period)

DIV= +*FCF+

LEV= +*FCF+

The Other Results (For firms that have less than 5-years dividend payment period)

DIV= +*FCF +


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LEV= +*FCF+

agebcy cost

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