*4.4. Independent Variables*

#### Agency Cost

Our first independent variable is the proxy for different agency cost measures. We measured the agency cost as the ratio of administrative expense to sales. The administrative expense includes the majority of the costs that have been incurred by the management, such as salaries, executive travel allowances, entertainment expenses, conferences and tour expenses, welfare payments, utilities, and other expenses that fall under this category. According to Li et al. (2008), Chinese managers misuse administrative expenses in automobiles, lavish office designs, recreational activities, and traveling. Therefore, administrative overhead can be regarded as a close proxy of agency costs.

Free cash flow is also considered to be a determinant of agency costs (Jensen and Meckling 1976). Still, the financial flexibility view suggests that managers intentionally keep a higher proportion of cash to meet future needs (Arslan-Ayaydin et al. 2014). An alternative definition of free cash flow as a measure of agency cost was used by Rahman and Mohd-Saleh (2008). First, we calculated free cash flow and growth opportunities following Chung et al. (2005a). Then, we created a dummy variable for agency cost that took the value of 1 if the firm in a particular industry in a specific year had free cash flow in excess of the industry median and a price-to-book ratio less than the industry median.

Three additional variables for measuring the extent of agency cost were provided as a robust check of our results. Earnings management, measured by absolute discretionary accruals following Dechow et al. (1995), is considered to be a proxy of agency cost. Research has determined that firms having high agency costs tend to manage their accruals (Christie and Zimmerman 1994; Teoh et al. 1998; Cormier and Martinez 2006). Next, we measured research and development expenditure (R&D-AC). R&D-AC is a dummy variable that takes the value of 1 if the firm 'i' in the year t has a price-to-book ratio less than the industry median and research and development expenditures higher than the industry median. Finally, we constructed an agency cost index through principal component analysis. We took the first principle component as the measure of agency cost.
