DIVIDEND PAYOUT RATIOS AS DETERMINANTS OF EARNINGS RESPONSE COEFFICIENTS - A TEST OF THE FREE CASH FLOW THEORY

This paper tests Jensen's (1986a) free cash flow theory that managers overinvest retained earnings by undertaking negative-NPV projects. The test is based on the theory's implication that earnings response coef ficients depend positively on payout ratios. It is supported by the da ta for a sample of 112 firms over the 1951-86 period. Another test fin ds that the returns on retained earnings are lower than proxies for th e market's required rate of return, as implied by the free cash flow t heory. However, the sample firms' Jensen's alphas are reliably positiv e, suggesting that caution is warranted in interpreting the results.