Dividend policy determinants: an investigation of the influences of stakeholder theory

Financial Management (Financial Management Association), Autumn, 1998 by Mark E. Holder, Frederick W. Langrehr, J. Lawrence Hexter

Following the approach used by Lloyd et al. (1985), we also use the natural log of sales from Compustat PC Plus as a size proxy.(3) The natural log of sales corrects for scale effects by treating as equal the same percentage variation, rather than the same numerical variation.

C. Agency Cost Variables

We use insider ownership, measured by the percentage of total shares outstanding held by insiders, as a measure of agency costs. As ownership by management increases, agency costs decline, since the managers bear more of the wealth effects of their decisions (Subrahmanyam, Rangan, and Rosenstein, 1997). Since larger firms tend to have more shareholders, we remove effects due to firm size by regressing the percentage of stock held by insiders against the natural log of sales. The residuals are used in the final regression. We expect a negative relation between the percentage of shares held by insiders, controlled for size, and the dividend-payout ratio. Insider ownership data were obtained from the Spectrum 6 publication of CDA Investment Technologies (Computer Directions Advisors), which lists insider ownership based on SEC forms three and four.(4) Only direct ownership is included as part of the shares held by insiders.

Our second measure of agency costs is the monitoring of managers by shareholders. If a shareholder holds a substantial fraction of the firm's equity, an institutional investor, for example (Bathala, Moon, and Rao, 1994), then monitoring by this individual is a low-cost activity as a percentage of the individual's wealth in shares. Conversely, when ownership is dispersed among many shareholders, monitoring by those shareholders becomes a high-cost activity. Less concentrated ownership of a firm creates higher agency costs for that firm, and therefore increases the need for other agency-cost-reducing mechanisms. As a result, we expect that firms with lower concentrations of ownership, or a relatively larger number of shareholders, will have higher dividend payouts.

The hypothesized relation between dividend payout and ownership concentration is positive. To measure the concentration of ownership, we use the natural log of the number of common shareholders (Rozeff, 1982) from Compustat PC Plus. However, firm size is related to the number of shareholders. To remove size effects, we regress the natural log of the number of common shareholders on the natural log of sales and use the residual in the final regression.

Our third measure of agency costs is the free cash flow of a firm. Jensen (1986a) defines free cash flow as cash flows that are in excess of funds required for all projects that have positive net present values after those projects are discounted at the cost of capital. Firms with numerous growth opportunities have a lower level of free cash flow than firms with few growth opportunities. Having a relatively lower level of free cash flow means that agency costs will be lower and the need for dividends to reduce agency costs will be lessened. Alternatively, for firms with fewer growth investments, management can use free cash flow for the consumption of perquisites or investment in negative net-present-value (NPV) projects, leading to increased agency costs. To reduce this suboptimization and reduce agency costs, firms with higher free cash flows may have higher dividend payouts. Therefore, our hypothesized relationship between free cash flow and dividend payout is positive.