2.1. Agency Cost of Free Cash Flow and Dividend Payment
Free cash flow provides information about a firm's resistance to internal growth and financial constraints. It serves as the primary source of cash that firms rely on to fund dividend payments. According to Myers and Majluf (1984), firms utilize free cash flow when they are unable to obtain external funds due to inefficient or imperfect markets or when managers and capital providers face a situation of information asymmetry. The excess cash can also be utilized to mitigate price fluctuations, ensuring continued investment funding, particularly during periods of declining generated funds. Similarly, managers enhance firm value through free cash flow to maintain a balance between cash inflows and. However, it is important to consider that dividend payments are influenced when there is an agency cost of free cash flow. Jensen and Meckling (1976) proposed agency theory, which explores the dynamics of relationships and conflicts of interest between different stakeholders within an organization. In a similar vein, Jensen (1986) introduced the free cash flow hypothesis, which examines the potential effects of surplus cash flow on decision-making and agency conflicts between managers and shareholders. These theories provide valuable frameworks for understanding the complexities of corporate governance and financial management. In fact, free cash flow creates a desire among managers for the perquisite consumption, utilizing available funds for various activities that promote their personal utility, thereby harming shareholder returns (Stulz, 1990). Managers tend to invest in projects that bring indirect personal benefits rather than distributing money to shareholders (Kadioglu and Yilmazb, 2017; Kwon et al., 2021). Similarly, Jensen (1986) argues that dividends serve as a tangible and reliable commitment from managers to distribute cash to shareholders. This commitment is considered as an indication that the firm has a low agency cost of free cash flow. Zhanga et al. (2016) also suggest that while free cash flows can result in higher levels of investment, an elevated level of investment during periods of unfavorable future opportunities may indicate the presence of an agency problem. According to their perspective, when companies generate significant free cash flows, they have additional funds available for investment purposes. Increased investment can be viewed as positive when it reflects the company's ability to capitalize on profitable growth prospects. However, concerns arise when companies exhibit a higher level of investment during periods characterized by poor future opportunities. This pattern suggests a potential agency problem within the organization, where managers, driven by their own interests or incentives, engage in excessive or unwarranted investment activities that are not aligned with the long-term interests of shareholders. Such behavior can result in the misuse or wasteful allocation of resources, potentially undermining the firm. Building upon prior research, I support the Modigliani & Miller (1961) proposition, which suggests that the existence of agency costs related to free cash flows can restrict the availability of funds for dividend payments. Thus, I advance the first hypothesis.
Hypothesis 1: Agency cost of free cash flow has a negative effect on Dividend Payment
2.2. The Moderating Effect of Debt Financing
Within the framework of the agency problem between shareholders and creditors, the choice of debt presents one of the most important decisions that affect shareholder wealth. According to Flannery's study in 1986, debt financing discourages overinvestment of free cash flow and acts as a signal to investors, demonstrating the managers' commitment to meeting future cash flow obligations and their acceptance of monitoring by lenders. Similarly, Lang et al (1996) documented that firms with high agency costs of free cash flow use relatively more debt as a disciplinary mechanism to reduce overinvestment problems and avoid investing in low-return projects. If managers choose to misuse free cash flow for personal gain instead of fulfilling the firm's obligations, it can have serious implications, particularly in regard to debt repayment.
In such cases, the company may face difficulties in meeting its debt obligations, potentially leading to default. This outcome not only puts the managers' jobs at risk but also damages their professional reputation. In addition, high leverage is associated with better efficiency by reducing the problems associated with the separation of management control and increasing firm value through encouraging managers to take more action in favor of stakeholders. Managers who anticipate better firm productivity will have an advantage in taking on debt to convince the market to assess it at its fair price. However, if managers give a false signal regarding firm productivity, the risk of bankruptcy increases, especially with higher levels of debt. This also limits the firm's ability to increase new debt, thereby forcing the loss of significant investment opportunities (Harris and Raviv, 1990). Using a panel dataset consisting of 91 Indian manufacturing firms listed in the BSE 200 Index, Pandey and Sahu (2019) found that the positive impact of debt on firm profitability can be attributed to its ability to address the conflict of interest between managers and owners. Debt serves as a disciplinary tool, motivating managers to prioritize the welfare of the firm's shareholders. This discipline can arise from the fear of liquidation arising from the fixed committed payouts or the reduction of available free cash flow that managers can access. In both scenarios, debt acts as a catalyst, aligning managerial actions with the objectives of the firm's principals. Again, creditors can impose restrictions on highly leveraged firms by influencing the decision of profit distribution to shareholders and by increasing the interest rate on new debt. This can restrain the managerial capacity to actively pursue projects that generate positive net present value.
The above discussion supports the idea that assumes a crucial and integral role in minimizing the agency cost of free cash flow and, consequently, enhancing shareholder wealth. However, the present study aims to analyze the decision regarding the structure of debt, which can encompass both short-term and long-term debt. Firms need short-term financing to fund their investments in working capital and ensure the continuity of production and sales. Additionally, they utilize short-term debt as a means to address their long-term investment demands (Chen and Sun, 2023). According to the agency theory of Jensen and Meckling (1976), short-term debt helps mitigate the problem of underinvestment and, as a result, increases shareholder value. Using a sample of 5763 unique firms in 23 countries, Anginer et al (2021) suggested that Short-term debt can serve to mitigate agency conflicts and information asymmetry between managers and shareholders by subjecting managers to more frequent monitoring. Lenders monitor the firm's credit rating to determine whether to renew credit requests and, in case of non-repayments, they can transfer control to creditors. This finding is in accordance with the empirical support provided by Tosun and Senbet (2020) who suggest a substitution effect between short-term debt and good governance. Therefore, I anticipate the presence of a comparable relationship within the sample under examination and I suggests that short-term debt can effectively reduce the agency costs associated with free cash flow and consequently lead to higher returns for shareholders. Thus, I propose the second hypothesis.
Hypothesis 2: An increase in short-term debt negatively affects free cash flow and has a positive effect on Dividend Payment.
From the previous discussion, we argue that there is a belief that firms actively employ a strategy of using short-term debt as a means to mitigate financing costs and address management agency problems. However, other scholars dispute the idea that long-term debt financing can effectively mitigate the agency costs associated with free cash flow. One of the primary advantages is the relatively low financing costs associated with this type of funding, which can be attributed to tax-deductible interest. When a company takes on long-term debt, the interest paid on that debt is often tax-deductible. This implies that the company can reduce its taxable income by deducting the interest expense from its earnings. As a result, the firm's overall tax liability decreases, leading to a lower cost of financing. This can be particularly advantageous when compared to other forms of financing, such as equity financing, where there are no tax benefits associated with the cost of capital. Overall, the tax-deductible interest associated with long-term debt financing can provide firms with a cost advantage, enabling them to optimize their capital structure and allocate resources effectively to support their growth and value creation objectives.
Long-term debt financing offers stability in terms of interest payments due to its structured repayment schedule and often fixed interest rates. This stability can have a positive influence on a firm's value. It is commonly utilized to finance tangible assets that include property, plants, equipment, machinery, infrastructure, and other physical resources. According to D'Mello and Miranda (2010), long-term debt can effectively address agency problems by reducing excess investments and lowering abnormal capital expenditures. In circumstances where conflicts of interest between managers and shareholders are prominent, long-term debt financing serves as a mechanism to mitigate these conflicts and foster more disciplined investment decision-making. It imposes financial obligations, such as interest and principal payments, which act as a constraint on managers' discretion to allocate free cash flow for non-value-maximizing purposes. This limitation on available cash reduces managers' discretion and helps prevent the risk of wasteful spending. Furthermore, long-term debt providers, including bondholders and lenders, have a vested interest in ensuring that companies meet their debt obligations. They actively supervise the company's financial performance and investment decisions to safeguard their investment. This external monitoring serves as a means of regulating managerial behavior, thereby reducing the agency costs associated with free cash flow by holding managers responsible for their decisions. This can foster alignment between managers and shareholders by creating incentives for managers to use free cash flow to generate sufficient funds for debt services. The shared advantage experienced by the company and its creditors incentivizes managers to direct free cash flow towards projects and initiatives that enhance value and prioritize the interests of shareholders. This deliberate allocation serves to mitigate the likelihood of agency conflicts, fostering a more harmonious relationship among stakeholders. In summary, the utilization of long-term debt enables companies to effectively address agency costs related to free cash flow. This is achieved through the implementation of financial constraints, external monitoring, and the pursuit of a common alignment of interests between managers and shareholders. Consequently, long-term debt helps ensure that free cash flow is utilized in a manner that maximizes shareholder value while minimizing the risks of value-destroying investments and discretionary spending. Therefore, my third hypothesis documents a negative association between long-term debt and the agency cost of free cash flow, which, in turn, positively affects shareholder returns. Thus, I propose the third hypothesis.
Hypothesis 3: An increase in long-term debt negatively affects free cash flow and has a positive effect on dividend payment.