J. Service Science & Management, 2010, 3, 408-418
doi: 10.4236/jssm.2010.34047 Published Online December 2010 (http://www.SciRP.org/journal/jssm)
The Impacts of Free Cash Flows and Agency Costs
on Firm Performance
George Yungchih Wang
Department of International Business, National Kaohsiung University of Applied Sciences, Kaohsiung, Taiwan, China.
Received August 6th, 2010; revised October 10th, 2010; accepted November 17th, 2010.
ABSTRACT
This paper investigates how free cash flow (FCF) is associated with agency costs (AC), and how FCF and AC influence
firm performance. The research purpose is therefore threefold. Specifically, the study is to explore the impact of FCF
on AC, to re-examine the free cash flow hypothesis, and to test the agency theory based on the empirical data from
Taiwan publicly-listed com panies. The study uses the variable of standard free ca sh flow to measu re FCF and six proxy
variables to measure AC. It is found that FCF has a significant impact on AC with two contrary effects. On one hand,
FCF could incur AC due to perquisite consumption and shirking behavior; on the other hand, the generation of FCF,
resulting from internal operating efficiency, could lead to better firm performance. Excluding insignificant proxy vari-
ables of AC and including only total asset turnover and operating expense ratio as sufficient AC measures, the study
finds evidence to support the agency theory, meaning AC has a significantly negative impact on firm performance and
stock return. In contrast, the study finds a significan tly positive relation between FCF and firm performance measures,
indicating lack of evidence supporting the free cash flow hypothesis. The study provides a better understanding of the
associatio n am o n g FC F, AC , a n d fi rm performance.
Keywords: Agency Theory, Free Cash Flow Hypothesis, Free Cash Flows, Agency Costs, Firm Performance
1. Introduction
The main purpose of business administration and finan-
cial management is to pursue perpetual growth of a cor-
poration such that the wealth of its stockholders could be
maximized. Ever since the disastrous financial tsunami in
2008, corporate financial distresses occurred to several
well-known giant enterprises, including Citibank and
American International Group (AIG). The U.S. govern-
ment thus initiated financial bailout projects in order to
save these corporations from financial distress. To our
surprise, several companies, after receiving government
bailout funding, proposed enormous bonus compensation
plans to the management as well as the board of directors.
For instance, AIG decided to issue a bonus compensation
plan amounted to $165 million dollars to senior man-
agement even though the plan had been severely criti-
cized by the press. This notorious case presented a di-
lemma to government policy-makers whether the gov-
ernment should assist these troubled companies out of
corporate financial distress [1,2].
Academicians, however, examine the issue in order to
find an answer for the dilemma from several different
perspectives. For example, firms are suggested to im-
prove their corporate governance and business ethics in
order to reduce the self-interest motives of management
and to avoid management’s moral hazard, while agency
theory examines how management’s behavior could be
directed at stockholder’s interest by reducing agency cost.
According to Brush, Bromiley, and Hendrickx [3], agen-
cy theory holds based on three premises: First, the goal
of management is to maximize his/her personal wealth
instead of stockholder’s wealth. Second, management’s
self-interest motivates waste and inefficiency in the
presence of free cash flows (FCF). Third, agency costs
are incurred to the burden of stockholders because of
weak corporate governance.
The original definition of FCF, according to Jensen [4],
is net cash flows of operating cash flows less capital ex-
penditure, inventory cost, and dividend payment. The
definition is criticized to be lack of accounting precise-
ness. Dittmar [5] elaborated on FCF as net cash flows
that are at the management’s discretion without affecting
corporate operating activities. In the paper, FCF, accord-
ing to Lehn and Poulsen [6], is defined as net operating

The Impacts of Free Cash Flows and Agency Costs on Firm Performance409
income before depreciation expenses, less tax expenses,
interest expenses, and stock dividends, scaled by net
sales.
This study, based on the agency theory and the free
cash flows hypothesis, aims to explore how free cash
flows impact on agency costs and thus on firm perform-
ance with the data of Taiwan publicly-listed companies.
Free cash flows are the discounted value of all the oper-
ating cash flows net of the needs of positive NPV pro-
jects. In addition to the accounting concept, free cash
flows also represent idle cash flows at the discretion of
management. The free cash flows hypothesis, proposed
by Jensen [4], states that management could prompt to
invest unnecessary, negative NPV projects when there
are too much free cash flows in the management’s hands.
Furthermore, the hypothesis implies that a higher level of
free cash flows would lead t to more of unnecessary ad-
ministrative waste and inefficiency.
Specifically, this study is directed to examine the va-
lidity of the FCF hypothesis and agency theory, and the
linkage between the two theories. The research purpose
is therefore three-fold: First, since earlier literature sim-
ply regarded FCF as agency costs (see Chung, Firth, and
Kim [7,8]) and failed to build up the linkage between
FCF and agency costs, the study was intended to fill up
the research gap by investigating how the FCFs at man-
agement’s discretion would influence agency costs. Sec-
ond, since the results of empirical studies on testing the
FCF hypothesis were inconsistent, the study would like
to empirically test how FCF would impact on firm per-
formance by using the data of public-listed companies on
Taiwan Stock Exchanges (TWSE). Third, we would also
like to re-examine the agency theory by testing how other
agency costs would influence firm performance.
The rest of the paper is organized as follows: Section 2
reviews the literature on the free cash flows hypothesis
and the agency theory. Section 3 presents the research
methodology, the hypotheses, and the testing models.
Section 4 presents our statistical results. Section 5 pro-
vides concluding remarks.
2. Literature Review
2.1. The Free Cash Flows Hypothesis
Although the first complete study regarding the agency
theory was conducted by Jensen and Meckling [9], yet
the idea of FCF was originally proposed by Jensen [4], in
which FCF is defined as net cash flows after deducting
the needs of positive NPV projects. Since FCF is finan-
cial resources at the management’s discretion to allocate,
it is also called idle cash flows. Jensen [4] argued that too
much FCF would result in internal insufficiency and the
waste of corporate resources, thus leading to agency
costs as a burden of stockholder’s wealth. Jensen [10]
empirically examined the agency problem and thus as-
serted that FCF was accused of the main reason why the
investment return in the US companies fell below the
required rate of return in 1980s.
In additional to FCF, Jensen [10-13] argued that the
self-interest motive of management was an important
factor leading to agency costs. This was especially obvi-
ous when stockholder’s and management’s interests were
in conflict, and consequently stockholder’s interest was
always dominated by management’s. Brush et al. [3]
asserted that weak corporate governance caused the inef-
ficiency in the allocation of free cash flows since the
corporate board of directors was directed at the policies
in favor of management’s interest at the expense of
stockholder’s wealth.
The FCF hypothesis states that when a company has
generated an excessive surplus of FCF and there are not
profitable investment opportunities available, manage-
ment tends to abuse the FCF in hands so as to resulting in
an increase in agency costs, inefficient resource alloca-
tion, and wrongful investment. Brush et al. [3] found that
sales growth was most beneficial to companies being
lack of cash flows, but not necessarily to companies with
sufficient FCF and thus supported the FCF hypothesis.
Chung et al. [7] also found that excessive FCF might
have a negative impact on corporate profitability and
stock valuation and thus suggested the control hypothesis
of institutional investors.
Not all empirical evidence supported the FCF hy-
pothesis. For instance, Gregory [14] examined how FCF
influences merger performance based on the UK data and
found that mergers with a higher level of FCF would
perform better than those with a lower FCF level as evi-
dence invalidating the FCF hypothesis. In addition, the
studies conducted by Szewcyzk, Tsetsekos, and Zantout
[15] and Chang, Chen, Hsing, and Huang [16] discovered
empirical evidence in support of the investment opportu-
nity hypothesis that investors would most favor compa-
nies with both substantial FCF and profitable investment
opportunities in stock valuation.
2.2. Agency Costs
The agency problem was originally raised by Berle and
Means [17] who argued that agency costs might be in-
curred in the separation of ownership and control due to
inconsistent interests of management and stockholders.
Jensen and Meckling [9] suggested that the incomplete
contractual relationship between the principal (stock-
holders) and the agent (management) might cause the
agency problem. In general, the agency problem caused
by management would cause a loss in stockholders’
wealth in the following ways: First, management, from

The Impacts of Free Cash Flows and Agency Costs on Firm Performance 410
the aspect of self-interest motive, would increase perqui-
site consumption and shirking behavior, which in turns
led to an increase in agency costs. Second, management
might not choose the highest NPV investment project,
but the one that maximized his own self-interest, which
would expose stockholders to unnecessary investment
risk. Therefore, management’s decision might cause the
firm’s loss in value because the best project was not
chosen.
It was obvious that the agency problem caused by
management would burden the stockholder’s loss, yet it
was not clear how the agency costs were defined as well
as measured. Early literature, such as Jensen and Meck-
ling [9] and Jensen [4,11,12], argued that there were at
least three forms of agency costs: monitoring cost of
management’s actions, bonding cost of restrictive cove-
nants, and residual loss due to suboptimal management’s
decisions. Jensen [4,11,12] linked the agency problem
with free cash flows such that management might abuse
free cash flows at their authority when investment op-
portunities were not readily available to the firm. There-
fore, free cash flows to management were agency costs
to stockholders.
To tackle the agency problem, two contrasted ap-
proaches, the refraining approach and the encouraging
approach were suggested. Kester [18] and Gul and Tsui
[19] took the refraining approach and argued that an in-
crease in financial leverage would sufficiently reduce the
agency costs since management is subjective to legal
bonding of repaying debt and interest, which in effect
might decrease the abuse of free cash flows. In addition,
Shleifer and Vishny [20] and Bethel and Liebeskind [21]
proposed that corporate takeover could discourage man-
agement’s incentive to perquisite consumption and shir-
king behavior. Furthermore, Crutchley and Hansen [22]
implied that the firm could attempt to distribute idle cash
flows to stockholders by stock repurchase or dividend
payments to avoid the abuse of free cash flows.
By contrast, Lehn and Poulsen [6], Fox and Marcus
[23], and Dial and Murphy [24] suggested the encourag-
ing approach that a firm could change management’s
action to be more in favor of stockholders by increasing
the shares held by management.
Although abundant literature has reviewed the agency
theory, yet the measurement of agency costs was still not
clearly defined, thus depending on proxy variables. Ac-
cording to literature, there were seven proxy variables
suggested to measure agency costs: They are total asset
turnover [25]; Singh and Davidson [26]), operating ex-
pense to sales ratio [25], administrative expense to sales
ratio [26], earnings volatility, advertising and R & D ex-
pense to sales ratio, floatation cost (Crutchley and Han-
sen [22]), and free cash flows [7,8]. Therefore, the paper
also intended to empirically test which proxy variable
would better serve as the measurement of agency costs.
3. Research Methodology
3.1. Research Scheme
As mentioned earlier, there were three major research
purposes of this study: Firstly, we would like to investi-
gate how free cash flows would influence agency costs.
Since literature had not identified a proper measure for
agency costs, six proxy variables were surveyed for the
testing purpose in the presence of agency costs. Secondly,
with the empirical data from Taiwan Stock Market, this
paper intended to re-examine the free cash flows hy-
pothesis, i.e., how FCF would impact firm performance.
Thirdly, this paper also intended to empirically examine
the linkage between agency costs and firm performance.
Therefore, the research scheme was constructed to satisfy
the mentioned research purposes, as shown in Figure 1.
3.2. Hypotheses and Models
As shown in Figure 1, four hypotheses were proposed to
answer our research questions. In the section, hypotheses
and regression models were constructed with the use of
ordinary lease square (OLS) method.
3.2.1. Free Cash Flows and Agency Costs
According to Jensen [4,11,12], the free cash flows hy-
pothesis stated that as free cash flows became too lavish
to the firm, the management tended to increase perquisite
consumption and devour more corporate resources, thus
causing a loss in firm value. However, the free cash
flows hypothesis failed to address how free cash flows
would impact on agency costs. Thus, hypothesis 1 was
proposed to state the inverse relationship between free
cash flows and agency costs.
H1: free cash flows have a positive impact on agency
costs.
Since related literature failed to clearly define agency
costs, six proxy variables were chosen to test H1. The
Agency Cost
Operating
Performance Firm Value Stock Return
H1
H4H3H2
Free Cash Flows
Figure 1. Research scheme.

The Impacts of Free Cash Flows and Agency Costs on Firm Performance411
tt
regression models were therefore constructed as follows:
01 123ttt
AssTFCFSize DA



  
tt
(1)
01 123ttt
OpeRFCFSize DA



  
tt
(2)
01 123ttt
AdmTFCFSize DA



  
t
(3)
01 123ttt
ARDRFCFSizeDA t



  
tt
(4)
01 123ttt
NOIVolFCFSizeDA



  
tt
(5)
01 123ttt
NIVolFCFSizeDA



  
t
t
(6)
where FCFt-1 denotes free cash flows at time t-1,
AssTt denotes total asset turnover at time t,
OpeRt denotes operating expense ratio at time t,
AdmRt denotes administrative expense ratio at time t,
ARDRt denotes advertising and R & D expense ratio at
time t,
NOIVolt denotes volatility of net operating income at
time t,
NIVolt denotes volatility of net income at time t,
Sizet denotes firm size at time t, a control variable, and
DAt denotes debt ratio at time t, a control variable.
3.2.2. The Impacts on Firm Performance
According to the free cash flows hypothesis and the
agency theory, free cash flows and agency costs had a
negative impact on firm performance. Recent empirical
studies also supported this argument. For example, Lang
et al. [27] examined 101 merger cases and found that free
cash flows might deteriorate the q ratio of a firm in mer-
gers and acquisitions. Chung et al. [7] found that free
cash flows might incur agency costs so as to inversely
influence short-term operating cash flows, thus under-
mining long-term firm value. Chang et al. [16] found
evidence to support a significant inverse relationship
between free cash flows and stock returns. This study
therefore hypothesized that free cash flows and agency
costs had a negative impact on operating performance,
firm value, and stock return. To test the hypotheses, re-
turn on assets (ROA) and return on equity (ROE) were
chosen to proxy for operating performance, and Tobin’s
q ratio for firm value. The hypotheses and regression
models were constructed as follows:
H2: Free cash flows and agency costs have a negative
impact on operating performance.
01 123
45 6
789
ttt
tt
tttt
ROEFCFAssT OpeR
A
dmR ARDR NOIVol
NIVol Size DA
 



 
 

(7)
01 123
45 6
789
ttt
tt
tttt
ROAFCFAssT OpeR
H3: Free cash flows and agency costs have a negative
impact on firm value.
01 123
45 6
78910
tttt
tt t
ttt t
qFCFAssTOpeR
AdmR ARDR NOIVol
NIVolRmSizeDA t




 




 

 
(9)
where Rmt denotes market return at time t, a control va-
riable.
H4: Free cash flows and agency costs have a negative
impact on stock return.
01 123
45 6
78910
tttt
tt t
ttt t
RiFCFAssT OpeR
AdmR ARDR NOIVol
NIVolRmSizeDAt




 




 

 
(10)
3.3. Variable Definition
In the sub-section, the specifications and definitions of
all the variables in the regression models are discussed.
3.3.1. Independent Variables
3.3.1.1. Free Cash Flows (FCF)
According to Lehn and Poulsen [6] and Lang et al. [27],
free cash flows could be defined as operating net income
before depreciation expense, less corporate income tax,
interest expenses, and cash dividends. The advantage
of the definition was that it indicated how much the ac-
tual free cash flows were available for management to
exercise. Under the consideration of firm size, free cash
flows were scaled by net sales (Lehn and Poulsen [6];
Gul and Tsui [19,28]). The standardized free cash flows
were expressed as follows:
-- --
tttt
tt
OCFTax IExpCDiv PDiv
FCF Sales t
(11)
where OCF denotes operating cash flows, Tax corporate
income tax expense,
IExp interest expense, CDiv common stock dividends,
PDiv preferred stock dividends, and Sales net sales.
3.3.1.2. Agency Costs
t
t
A
dmR ARDR NOIVol
NIVolSize DA





 
 

(8)
As mentioned earlier, literature showed that there are
seven proxy variables for agency costs, i.e., total asset
turnover, operating expense to sales ratio, administrative
expense to sales ratio, advertising and R&D expenses to
sales ratio, volatility of net operating income, volatility
of net income, and flotation cost ratio. Since flotation
cost was not available in the Taiwan Economic Journal
Database, the other six variables were chosen to measure
agency costs. It is important to note that total asset turn-
over is the only inverse proxy variable for agency costs,
meaning that agency costs increase as total asset turnover
decreases. The six proxy variables are defined as follows:

The Impacts of Free Cash Flows and Agency Costs on Firm Performance 412
t
tt
Sales
AssT
A
ssets
 (12)
where AssTt denotes total asset turnover, Sales net sales,
and Assets total assets.
t
tt
OpeE
OpeR Sales  (13)
where OpeR denotes operating expense ratio and OpeE
operating expenses.
t
tt
A
dmE
AdmR Sales  (14)
where AdmR denotes administrative expense ratio and
AdmE administrative expense.
t
tt
A
RDE
ARDR Sales  (15)
where ARDR denotes advertising and R&D expense ratio
and ARDE advertising and R&D expenses.
t
tt
NOI
NOIVolSTD Sales




(16)
where NOIVol denotes volatility of net operating income,
NOI net operating income, and STD standard deviation.
t
tt
NI
NIVolSTD Sales




(17)
where NIVol denotes volatility of net income and NI net
income.
3.3.2. Depe ndent Variables
3.3.2.1. Operating Performance
Return on asset (ROA) and return on equity (ROE) are
the most commonly adopted measures for corporate op-
erating performance [29-32]. The former demonstrates
firm performance on total assets, while the latter meas-
ures the return for stockholders. ROA and ROE are de-
fined as follows, respectfully:

1
1 2
t
ttt
NI
ROA
A
sset Asset

 (18)
t
tt
NI
ROE Equity  (19)
where Equity denotes equity.
3.3.2.2. Firm Value
Empirically, Tobin’s q ratio is commonly suggested as a
proxy for firm value, as shown in Lang et al. [27] and
Fama and French [33]. The q ratio is defined as follows:
tt
tt
t
M
VA PSDebt
qTAB

 (20)
where MVA denotes market value of common equity, PS
market value of preferred equity, Debt book value of
debt, and TAB book value of total assets.
3.3.2.3. Stock Return
Stock return is calculated as the holding period return
from time t-1 to t, expressed as follows:
1
1
tt
tt
PP
Ri P



 (21)
where, Ri denotes stock return and P stock price.
3.3.3. Cont rol Variables
According to literature, four commonly used control va-
riables were chosen to control their influences on de-
pendent variables. Demsetz and Lehn [34] argued that a
larger firm may lead to a higher firm value since more
available corporate resources are transformed into out-
puts. Fama and French [35] suggested that there is a pos-
itive relationship between firm size and firm performance.
More studies supporting the effect of firm size could be
seen in Gul and Tsui [19], Grullon and Michaely [36],
and Singh and Davidson [26]. For empirical purpose,
firm size is defined as follows:

ln
t
Size Sales

t
(22)
In addition, to control how financial leverage could in-
fluence firm performance, the debt ratio is also included
in the regression models. (Myers [37]; Easterbrook [38])
t
tt
Debt
DA
A
sset
 (23)
where DA denotes debt ratio and Debt total debt.
To control the impact of systematic risk on market
value of a firm, market return is also introduced accord-
ing to Fama and French [39]. Market return is defined as
follows:
1
1
tt
tt
X
X
Rm X



 (24)
where X denotes market index.
4. Regression Results
4.1. Descriptive Statistics and Correlations
To test the hypotheses, the data are based on all the pub-
licly listed companies on Taiwan Stock Exchange. The
main data is collected from Taiwan Stock Exchange and
Taiwan Economic Journal. After the deletion of incom-
plete company data, 505 companies are selected for the
time period ranging from Years 2002 to 2007. Table 1

The Impacts of Free Cash Flows and Agency Costs on Firm Performance413
provides descriptive statistics for data screening.
For the purpose of checking correlations and multicol-
linearity, Table 2 provides the Pearson correlation matrix.
As seen from Table 2, there appears no significant high
correlation between independent variables. To further
check the problem of multicollinearity, the value of va-
riance inflation factor (VIF) is also computed and dis-
played in the regression results in the next sub-section.
Since none of the VIF values exceeds 10, there appears
no multicollinearity between independent variables.
4.2. Regression Analysis
For testing H1, six regression models, i.e., Equations
(1)-(6), are conducted and the results are displayed in
Table 3. As shown in Table 3, all the six models indicate
a significant goodness of fit. Also, it can be found that
FCF has a significantly negative impact on total asset
turnover, operating expense ratio, and administrative
expense ratio. Although the sign of total asset turnover
appears to be negative as expected, yet those of operating
expense ratio and administrative expense ratio are incon-
sistent with the free cash flows hypothesis. It is therefore
argued that free cash flows could have a contrary effect
on agency costs. On one hand, the increase in free cash
flows could lead to an increase in agency cost, e.g., an
inefficiency of asset usage. The increase in free cash
flows, on the other hand, could be the result of efficient
expenditure management such that free cash flows are
inversely related to both expense ratios. The result in
Table 3 finds no evidence in supporting the free cash
flows hypothesis.
For testing how free cash flows and agency costs in-
fluence operating performance asin H2, Table 4 displays
the regression results based on the models in Equations
(7) and (8). As shown in Table 4, the F statistics of both
models are 255.814 (p < 0.01) and 272.629 (p < 0.01),
indicating a significant goodness of fit. The FCF variable
is found to be significantly, positively associated with
both ROA and ROE, indicating no evidence for the free
cash flows hypothesis. Among the six proxy variables of
agency costs, total asset turnover, operating expense ratio,
and administrative expense ratio are statistically signifi-
cant to operating performance, while only the former two
variables are consistent with the expectation of the
agency theory. Thus, if higher agency costs would un-
dermine a form’s operating performance, total asset
turnover and operating expense ratio would be better
measures for agency costs.
For testing H3, the regression result based on Equation
(9) is displayed in Table 5. As seen from Table 5, F sta-
tistic is estimated to be 73.853 (p < 0.01), indicating a
significant goodness of fit. The FCF variable is found to
be positively related firm value, lack of evidence sup-
porting the free cash flows hypothesis. Among the proxy
variables of agency costs, AssT, OpeR, AdmR, and
ARDR are statistically significant to firm value, while
only the former two variables are consistent with the ex-
pectation of the agency theory.
For testing H4, the regression result based on Equation
(10) is displayed in Table 6. As seen from Table 6, F
statistic is estimated to be 25.284 (p < 0.01), indicating a
significant goodness of fit. The FCF variable is found
to be positively related to firm value, lack of evidence
supporting the free cash flows hypothesis. Among the
proxy variables of agency costs, AssT, OpeR, ARDR,
and AdmR are statistically significant to firm value,
while the former three variables are consistent with the
expectation of the agency theory.
To sum up, Table 7 provides a summary table to indi-
cate the statistical significance of all the independence
variables. There are two major points that can be drawn
from Table 7. Firstly, all the results reveal no evidence
to support the free cash flows hypothesis, since FCF is
positively related to operation performance, firm value,
and stock return of a firm. The findings are consistent
with those in Gregory [14] and Chang et al. [16]. Sec-
ondly, total asset turnover and operating expense ratio
are found to be significantly consistent with the agency
theory. Since all the proxy variables neither support nor
negate the agency theory, it is difficult to make a conclu-
sion based on the evidence. However, if agency costs
actually have a negative impact on firm performance as
suggested in Ang et al. [25] and Singh and Davidson [26],
total asset turn over and operating expense ratio would be
better measures for agency costs since other proxy vari-
ables would generate inconsistent, contrary association
with firm performance measures.
5. Conclusions
Ever since Jensen and Mecking (1976) elaborated on the
agency theory arguing that the self-interest motive of
management could incur agency costs burdening the
wealth of stockholders, the study of agency theory has
been an important subject in corporate finance. The free
cash flows hypothesis proposed by Jensen [11,12] further
extended the knowledge regarding the agent’s behavior,
while neither the relationship between free cash flows
and agency costs was clearly addressed, nor the measures
for agency costs were properly identified by academia.
Therefore, the study aimed to empirically examine the
relationship between free cash flows and agency costs,
and to test both the free cash flows hypothesis and the
agency theory.
With the data of publicly listed companies on Taiwan
Stock Exchange, there are three major points drawn from
he evidence presented in the study. First, there are t

The Impacts of Free Cash Flows and Agency Costs on Firm Performance 414
Table 1. Descriptive statistics.
Variables Mean Median S.D. Min Max
FCF 0.0805 0.0704 0.1741 –4.0062 2.0136
AssT 0.8750 0.7600 0.5015 0.0200 3.3900
OpeR 0.9413 0.9502 0.1245 0.4082 3.2281
AdmR 0.0274 0.0071 0.0393 0.0000 0.1669
ARDR 0.1444 0.1172 0.1229 0.0000 0.5442
NOIVol 0.4502 0.4711 0.6312 0.1020 1.5673
Independent
Variables
NIVol 0.4128 0.4354 0.5562 0.0912 1.3445
Size 15.0661 14.8908 1.3698 9.9951 20.1955
DA 0.3863 0.3853 0.1530 0.0187 0.9268
PER 19.9376 12.0250 40.2067 0.0000 469.9000
Control
Variables
Rm 0.1428 0.0872 0.1041 0.0423 0.3230
ROE 0.0869 0.0954 0.1456 –0.9963 0.5405
ROA 0.0828 0.0786 0.0782 –0.2558 0.4155
q 0.8425 0.6960 0.6015 –0.1715 6.1749
Dependent
Variables
Ri 0.1959 0.1037 0.4719 –0.8122 2.4404
Table 2. Pearson correlation matrix.
Vari-
ables FCF AssT OpeR AdmR ARDR NOIVolNIVolSize DA PERRm ROE ROA q Ri
FCF 1
AssT –0.1275
** 1
OpeR –0.4860
**
–0.0477
* 1
AdmR –0.3212
*
–0.1221
**
0.4358
** 1
ARDR 0.2312
–0.1711
**
0.3212
* 0.000 1
NOIVol 0.0423 –0.0734 0.2313–0.013 0.083
** 1
NIVol 0.1312
* –0.1769 0.32420.01 0.020 0.0251
Size 0.1422
**
0.3093
**
–0.1508
**
–0.2375
*
0.2405
**
0.1232
*
–0.1832
* 1
DA –0.2573
**
0.2320
**
0.3600
** 0.4212 –0.1264 –0.0768–0.2202 0.1589 ** 1
PER –0.0333
–0.0444
* 0.02990.1253 –0.3241 * –0.1056 0.1076 –0.0391 *
–0.0490
* 1
Rm –0.0147
–0.0477
*
0.0240
** –0.2758 0.3245 ** 0.1465 0.2378 *
–0.0530
** 0.0142 0.0609 ** 1
ROE 0.3638
**
0.2182
**
–0.6233
**
0.3243
** 0.2532 –0.2650 *
0.3345
**
0.2365
**
–0.2533
** –0.0338–0.00151
ROA 0.4272
**
0.1300
**
–0.6687
**
0.2759
**
0.3783
**
–0.2104
**
0.2987
**
0.2378
**
–0.3178
**
–0.0740
** –0.0131 0.8763 ** 1
q 0.2772
** –0.0240 –0.4140 ** –0.1254 0.3524 0.0816 0.2312*0.1292* *
–0.2943
** –0.0074 0.0801 **
0.4849
**
0.6173
** 1
Ri 0.0147 0.0211
–0.1440
** –0.0213 0.2462 –0.1657–0.3867 0.0321–0.0092 0.03250.2497 **
0.2978
**
0.2806
**
0.3508
** 1
Note: * indicates p < 0.10; ** indicates p < 0.05.

The Impacts of Free Cash Flows and Agency Costs on Firm Performance415
Table 3. The regression results for testing H1.
Model 1a: AssT Model 1b: OpeR
Variables β t β t VIF
Const. –0.942 –9.147** 1.065 48.291**
FCF –0.261 –4.983** –0.303 –27.073** 1.111
Size 0.109 15.553** –0.012 –0.085** 1.061
DA 0.527 8.203** 0.213 15.460** 1.121
R² 0.139 0.360
Adj.R² 0.138 0.359
F-Statistic 135.493 472.146
p Value 0.000*** 0.000***
Model 1c: AdmR Model 1d: ARDR
Variables β t β t VIF
Const. 0.306 24.873** 0.057 5.706**
FCF –0.036 –5.772** –0.002 –0.336 1.111
Size –0.017 20.002** 0.000 –1.267 1.061
DA –0.019 –2.477** –0.034 –5.574** 1.121
R² 0.169 0.015
Adj.R² 0.168 0.014
F-Statistic 169.991 12.694
p Value 0.000** 0.000**
Model 1e: NOIVol Model 1f: NIVol
Variables β t β t VIF
Const. 651.449 1.435 227.825 0.276
FCF 194.758 0.846 431.877 1.031 1.111
Size –45.524 –1.482 –2.718 –0.049 1.061
DA 210.146 0.744 –674.971 –1.119 1.121
R² 0.001 0.001
Adj.R² 0.000 0.000
F-Statistic 0.880 1.090
p Value 0.451 0.352
Table 4. The regression results for testing H2.
Model 2a: ROE Model 2b: ROA
Variables β t β t VIF
Const. 0.339 10.409** 0.247 14.341**
FCF 0.240 17.866** 0.093 13.195** 1.489
AssT 0.068 14.933** 0.022 8.999** 1.238
OpeR –0.486 –22.781** –0.309 –27.501** 1.677
AdmR 0.133 3.433** 0.098 4.796** 1.325
ARDR –0.040 –0.854 –0.006 –0.228 1.020
NOIVol 0.000 0.751 0.000 0.971 1.011
NIVol 0.000 1.548 0.000 –0.396 1.004
Size 0.010 6.018** 0.008 8.957** 1.279
DA –0.085 –5.528** –0.067 –8.320** 1.302
R² 0.509 0.525
Adj.R² 0.507 0.523
F-Statistic 255.814 272.629
p Value .000** 0.000**
Note: * denotes p < 0.1; ** denotes p < 0.05.

The Impacts of Free Cash Flows and Agency Costs on Firm Performance 416
Table 5. The regression results for testing H3.
Model 3: q
Variables β t VIF
Const. 1.354 8.167**
FCF 0.136 2.001** 1.493
AssT 0.017 2.321** 1.240
OpeR –1.662 –15.345** 1.678
AdmR 1.718 8.743** 1.326
ARDR 0.859 3.642** 1.020
NOIVol –0.000 –0.245 1.011
NIVol –0.000 –1.247 1.007
Rm 0.563 5.588** 1.013
Size 0.073 8.442** 1.282
DA –0.662 –8.526** 1.303
R² 0.248
Adj.R² 0.244
F-Statistic 73.853
p Value 0.000**
Note: * denotes p < 0.1; ** denotes p < 0.05.
Table 6. The regression results for testing H4.
Model 4: Ri
Variables β t VIF
Const. 0.232 1.632
FCF 0.376 6.437** 1.496
AssT 0.042 2.125** 1.240
OpeR –0.363 –3.901** 1.685
AdmR 0.312 1.853* 1.327
ARDR –0.532 –2.627** 1.021
NOIVol 0.000 0.024 1.011
NIVol –0.000 –1.027 1.007
Rm 1.131 13.058** 1.016
Size 0.001 0.161 1.283
DA 0.138 2.068** 1.306
PER 0.000 1.178 1.013
R² 0.110
Adj.R² 0.105
F-Statistic 25.284
p Value 0.000**
Note: * denotes p < 0.1; ** denotes p < 0.05.

The Impacts of Free Cash Flows and Agency Costs on Firm Performance 417
Table 7. The summary table of statistical significance.
Statistical Significance
Free Cash
Flows Agency Costs
Dependent
Variable
FCF AssT OpeR AdmR ARDR NOIVol NIVol
AssT －
OpeR －
AdmR －
ARDR
NOIVol
H1
NIVol
ROE ＋ ＋ － ＋
H2 ROA ＋ ＋ － ＋
H3 q ＋ ＋ － ＋
H4 Ri ＋ ＋ － ＋ －
significant effects of free cash flows on agency costs, yet
the effects are contrary. On one hand, free cash flows
could increase the incentive for management to perqui-
site consumption and shirking, thus leading to an in-
crease in agency costs. On the other hand, free cash
flows are generated due to management’s operating effi-
ciency such that there may exist a negative relationship
between free cash flows and agency costs. Second, the
study finds lack of evidence supporting the free cash
flows hypothesis, meaning that free cash flows could
render a firm with investment opportunities which would
generate more values for the firm. Therefore, free cash
flows have a positive impact on firm performance. This
finding is consistent with the UK evidence found in
Gregory [14]. Third, the proxy variables of agency costs,
suggested by literature, are shown to have inconsistent
effects on firm performance. It is thus difficult to deter-
mine whether there exist a direct linkage between agency
costs and firm performance. However, if agency costs are
actually, inversely related to firm performance, as sup-
ported as in Ang et al. [25] and Singh and Davidson [26],
total asset turnover and operating expense ratio could
serve as better measures for agency costs.
The study is thus far the first one using Taiwan data to
empirically examine the relationship between free cash
flows and agency costs, the free cash flows hypothesis,
and the agency theory. For future research, it is suggested
to direct at examining the industry difference regarding
how free cash flows impact on firm performance.
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