In this study, the researcher utilises two agency cost proxies, which are asset utilisation and the interaction between the growth prospects and the free cash flow.
5.5.1 The industry adjusted asset utilisation ratio (adjTRN).
Ang, Cole and Lin (2000) have introduced the assets turnover ratio as a convenient proxy of the agency costs, and it has been used in the previous literature,
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e.g., Singh and Davidson III (2003), Florackis (2008), McKnight and Weir (2009), Henry (2010) and Ibrahim and Samad (2011), among others.
This ratio is used to measure the effectiveness of the management in generating sales using the firm’s assets, testing that the management has exerted the required efforts to generate these sales, and assessing the quality of investment decisions taken by the management. Ibrahim and Samad (2011) mention that the high turnover rate implies that firm has generated large sales volume, and definitely cash flows using a given level of assets; which reflects the management efficacy in using firm’s asset portfolios to generate value for shareholders.
Asset utilisation is considered as an inverse measure of agency costs; high asset utilisation ratio means the management is involved in utilising firm’s assets in creating value for shareholders, and hence lower agency costs. While low asset utilisation means that the management does not exert the sufficient effort, makes poor investment decisions (Ang, Cole and Lin, 2000) or the firm has unproductive assets (Ertugrul, 2005; Florackis, 2008; Henry, 2010), or mismanaging firm’s assets.
Considering the variation across industries in their asset intensity, and this measure is mainly tied to the assets employed and sales generated from this employment, in this study, the researcher will adjust this measure to the industry for the sake of controlling the variations across industries. Gompers, Ishii and Metrick (2003), Coles, Daniel and Naveen (2008), McKnight and Weir (2009) and Van Essen, Engelen and Carney (2013) reported that using the industry adjusted measures provide considerably strong results.
This measure is the natural log of one plus the industry assets turnover ratio. Asset turnover is the ratio of sale to total assets; this ratio was obtained from Datastream; then, the researcher calculated the industry median of asset turnover for each year, then subtract it from the from the company’s figure.
5.5.2 The interaction of free cash flow and growth prospects (QFCF).
Jensen (1986) argues that firms that generate large free cash flow, but having low growth prospects are more prone to agency problems than other firms, as managers can waste this money on unprofitable projects. Griffin, Lont and Sun (2010) demonstrate that prior studies provide evidence that supports this hypothesis. In
Chapter 5: Research Methodology
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addition to that, as the free cash flows are retained, the capital market cannot assess or monitor management’s decision which could suggest more managerial discretion and more agency costs (McKnight and Weir, 2009). High free cash flows with little growth opportunities mean that the firm is suffering from high agency problems which indicates high agency costs.
Free cash flow variable in this study is the sum of operating income before depreciation less the sum of total income taxes, interest expenses and dividends paid (Lehn and Poulsen, 1989) expressed as percentage to total assets (Doukas, Kim and Pantzalis, 2000; Doukas, McKnight and Pantzalis, 2005; McKnight and Weir, 2009; Henry, 2010).
Following the prior literature (e.g., Doukas, Kim and Pantzalis (2000); Doukas, McKnight and Pantzalis (2005); Florackis (2005); McKnight and Weir (2009); Belghitar and Clark (2014), among others) growth prospect is measured by Tobin’s Q. Tobin’s Q ratio is simply the firm market value divided by assets replacement value (Lindenberg and Ross, 1981; Chung and Pruitt, 1994). In this study, an approximation of Lindenberg and Ross (1981) Q ratio will be employed. Q ratio is the sum of the market value of outstanding common shares plus the value of preferred stocks plus total debt (short term debt + long term debt) divided by total assets. McConnell and Servaes (1995); McKnight and Weir (2009) and (Chen, Hou and Lee, 2012), among others, have employed this formula in estimating the Q ratio.
Based on the assumption that firms with free cash flow and low growth prospects are subject to more agency problems between owners and managers, and hence more agency costs, a dummy variable was constructed that takes the value of 1 if the firm’s growth prospect is less than the industry median and 0 otherwise. The firm is identified to have low growth prospects if the annual Q ratio is lower than the industry median, but if the firm’s Q ratio is greater than the industry median this indicates that this firm has high growth prospects. The interaction between the growth opportunities and free cash flows (QFCF) is calculated by multiplying the Q dummy variable by the free cash flows. The raw values of all of the variables utilised to compute the free cash flow and the Q ratio were obtained from DataStream.
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Based on this calculation, the researcher argues that this variable captures firms with potential agency problems represented in the interaction of free cash flows and low growth prospects. The potential agency costs are represented in the amount of free cash flow standardized by assets that are subject to be invested in unproductive projects. Other firms that free cash flow and high growth prospects take the value of zero.