Abstract
This study tests Jensen’s free cash flow theory which states that managers overinvest retained earnings in negative NPV projects. A data set of 238 firms listed on the Pakistan Stock Exchange for the period 1999 to 2016 is used. The results of the panel regression model show a significant positive association of the earnings response coefficient and dividend payout ratio, which supports the free cash flow theory in listed Pakistani firms. Moreover, the imposition of the capital gains tax and the financial crisis has further strengthened the positive relationship between ERC and dividend payout ratio.
Highlights
IntroductionThe existing literature documents a number of determinants of Earnings Response Coefficient (ERC) including beta (Collins and Kothari 1989; Biddle and Seow 1991; Easton and Zmijewski 1989; Biddle and Seow 1991; Hasanzade et al 2014; Zakaria and Daud 2013; Hakimpoor 2017), firm size (Easton and Zmijewski 1989; Mashayekhi and Aghel 2016), growth (Collins and Kothari 1989; Hasanzade et al 2014; Hakimpoor 2017), earnings growth (Yu and He 2013; Mashayekhi and Aghel 2016) and earnings persistence (Collins and Kothari 1989; Biddle and Seow 1991; Dhaliwal and Reynolds 1994).Dividend is an important part of stock return and its payment conveys a signal to investors in the market that the company is adhering to sound corporate governance (Jo and Pan 2009)
The results reported in table 4 show that dividend payout has a positive and significant relationship with the earninsg response which is in line with the free cash flow hypothesis of Jensen (1986)
This study tests the free cash flow theory of Jensen (1986) which states that managers overinvest retained earnings in negative NPV projects
Summary
The existing literature documents a number of determinants of Earnings Response Coefficient (ERC) including beta (Collins and Kothari 1989; Biddle and Seow 1991; Easton and Zmijewski 1989; Biddle and Seow 1991; Hasanzade et al 2014; Zakaria and Daud 2013; Hakimpoor 2017), firm size (Easton and Zmijewski 1989; Mashayekhi and Aghel 2016), growth (Collins and Kothari 1989; Hasanzade et al 2014; Hakimpoor 2017), earnings growth (Yu and He 2013; Mashayekhi and Aghel 2016) and earnings persistence (Collins and Kothari 1989; Biddle and Seow 1991; Dhaliwal and Reynolds 1994).Dividend is an important part of stock return and its payment conveys a signal to investors in the market that the company is adhering to sound corporate governance (Jo and Pan 2009). Corresponding to this, Jensen (1986) put forward the free cash flow hypothesis which advocates that companies overinvest free cash flow (cash left after all positive NPV projects are undertaken) in negative NPV projects rather than distributing these funds to the shareholders in the form of dividends. This is done by the management to escape the associated monitoring in case when funds are raised from capital markets resulting in agency costs. He supported the free cash flow hypothesis by concluding that returns on retained earnings are less than the market’s required rate of returns
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