The mediating effect of dividend payout on the relationship between internal governance and free cash flow

• DOI: https://doi.org/10.1108/CG-01-2018-0011
• Pages: 748-770
• Published date: 16 April 2018
• Date: 16 April 2018
• Author: Moncef Guizani
• Subject Matter: Corporate governance,Strategy

The mediating effect of dividend payout on

the relationship between internal

governance and free cash f‌low

Moncef Guizani

Abstract

Purpose –This paper aims to examine the mediating effect of dividend payout on the relationship

between internal governance mechanisms (board of directors and ownership structure) and the free

cash flowlevel.

Design/methodology/approach –Linear regressionmodels are used to investigate such relationships

applying data froma sample of 207 non-financial firms listed on the GulfCooperation Council countries’

stock markets between 2009and 2016. To test the significance of mediating effect, the author uses the

Sobel test.

Findings –The authorfinds a partial mediation effect of dividendon the relationship between bothboard

independence and managerialownership and the level of free cash flow. The results confirm the major

role of outside directors in corporate governance. This governance mechanism contributes to the

protection of shareholders’interests through a generous dividend policy. However,the author finds that

large managerialshareholdings increase the level of free cash flowthrough lower dividend payouts. This

result suggests that powerful managers follow their preference of retaining excess cash to their own

interests.

Practical implications –This paper offers insightsto policy-makers of emerging economies interested

in the development of the corporate governance. This study provides guidance for firms in the

constructionand implementation of theirown corporate governance policies.

Originality/value –The main contribution of the present paperis to examine the dividend payout as a

potential mediating variable between internal governancemechanisms and free cash flow. Moreover, it

highlights the issue of efficient management of substantial funds in Sharia-compliant and non-Sharia-

compliantfirms.

Keywords Corporate governance, Board of directors, Corporate ownership

Paper type Research paper

1. Introduction

How firms limit their free cash flow (FCF) in the face of low investmentopportunities is one of

the most important research topics in financial economics. This is the case because low

investment opportunities candistort the efficient allocation of internal funds and destroyfirm

value. When firms have limited investment opportunities, cash holdings are largely at risk of

being diverted by managers in projects that benefit them personally,thereby damaging the

interests of shareholders (Easterbrook, 1984;Jensen, 1986;Dittmar et al., 2003). The FCF

hypothesis of agency theory suggests that excess cash reserves increase managerial

discretion and provides managers with the incentive to pursue their own interests. The

problem stems from self-serving managers who divert cash flow to benefit themselves at

the expense of shareholders. Myers and Rajan (1998) suggest that managers tend to retain

more private benefits from liquid assets, and Byrd (2010) argues that FCF is available to

managers for discretionary purpose. Opler et al. (1999) highlight managers’ preference for

Moncef Guizani is Assistant

Professor at the

Department of Business

Administration, College of

Sciences and Humanities

Slayal, Prince Sattam Bin

Abdulaziz University,

Slayal, Saudi Arabia.

Received 8 January 2018

Revised 5 March 2018

Accepted 9 March 2018

PAGE 748 jCORPORATE GOVERNANCE jVOL. 18 NO. 4 2018, pp. 748-770, ©EmeraldPublishing Limited, ISSN 1472-0701 DOI 10.1108/CG-01-2018-0011

the control that comes with holding high levels of cash reserves. Apart from using FCF to

invest in projects with negative net present value (NPV), Kadioglu and Yilmaz (2017)

suggest that managers tend to make unnecessary expenditures that benefit themselves at

the expense of shareholders’ interests. According to Labhane and Mahakud (2016), the

excess amount of FCF in the hands of managers increases the agency cost, as they are

free to use these financial reserves for their own interests. To avoid any wasteful

expenditure, shareholders of such firms monitor the activities of managers. These

monitoring activities increase the firm cost of monitoring and hence increase the agency

cost.

One of the ways to reduce the FCF problem is to pay out more of these substantial cash

flows as dividends (Fairchild, 2010). Agency theory suggests that outside shareholders

prefer dividends to retained earnings becauseinsiders might squander cash retained within

the firm (Easterbrook, 1984;Jensen, 1986;Myers, 2000). Distributing cash to shareholders

reduces the chance that the managers may use the available resources inappropriately

(Jensen, 1986;Lang and Litzenberger, 1989). Kadioglu and Yilmaz (2017) argue that

dividends help check managers and create a discipline mechanism without the direct

intervention of shareholders. In parallel, studies in finance suggest that payouts lower

retained earnings and hence increase the need of managers to go to financial markets to

raise funds, where monitoring is offered at lower costs. (Easterbrook, 1984;Jensen, 1986;

La Porta et al., 2000;DeAngelo et al., 2006;Denis and Osobov, 2008;Guizani, 2014). To

the extent that external financial markets play a monitoring role, they presumably reduce

managers’ incentives to engagein wasteful consumptions.

On the other side, some studies identify a number of governance mechanisms that realign

the interests of agents and principals and so reduce agency costs. McKnight and Weir

(2009) argue that there is a range of optimal governance structures that are consistent with

performance maximizing (agency cost minimizing) outcomes. Richardson (2006) finds a

positive relationship between over-investment and FCF, which is consistent withthe agency

cost explanation. In this context, the author suggests that certain corporate governance

structures appear to mitigatethe problems associated to over-investment.

Beyond the direct effect of governance mechanisms on the FCF, I argue that these

mechanisms can indirectly influence the excessive cash flow through dividend payouts. In

this respect, La Porta et al. (2000) suggest that having sound corporate governance

practices in place can facilitate the redistribution process of excess cash flows in favor of

shareholders’ wealth. The authors discuss two opposing models of the relation between a

firm’s corporate governance quality and its payout policy: the outcome model and the

substitute model. In the outcome model, the payment of dividends is the result of effective

governance. Good governance reduces any misallocation of funds and makes

expropriation from shareholders more difficult. Accordingly, shareholders successfully

pressure managers to distribute excess cash (La Porta et al.,2000;Mitton, 2005;Jiraporn

and Ning, 2006;Adjaoud and Ben-Amar, 2010). In contrast, the substitute model stipulates

that the payment of dividends replaces other corporate governance mechanisms in

mitigating agency conflicts. In the extent that better-governed firms are associated with

lower agency costs, they are less likely to use dividends as a device to mitigate

managers–shareholders conflicts (La Porta et al.,2000;Hwang et al., 2013;John et al.,

2015).

Overall, previous studies have established two keys sets of relationships. To begin with,

there are a number of corporate governance characteristics that are known to have effects

on FCF (Richardson, 2006;McKnight and Weir, 2009). This relationship emerges according

to the role of corporate governance mechanisms in monitoring the firm’s managers. The

second key relationship that has been studied in the literature is that of dividends and F CF. As

previous research has shown, the firm’s dividend payout is typically related to redistribut ion

process of excess funds (La Porta et al.,2000;Mitton, 2005;Jiraporn and Ning, 2006;

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