The dividend policies of all‐equity firms: A direct test of the free cash flow theory

Abstract

Abstract This paper finds support for Jensen's (1986) hypothesis that dividends and debt are substitute mechanisms for controlling the agency costs of free cash flow. We find that dividend payout ratios of a sample of all‐equity firms are significantly higher than those of a control group of levered firms. Further, within the group of all‐equity firms, firms with lower managerial holdings have higher payout ratios. These results hold after controlling for free cash flow and growth rates. Overall, our evidence suggests that dividends and managerial ownership are substitute mechanisms for reducing agency costs in all‐equity firms.