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Payout Policy, Financial Flexibility, and Agency Costs of Free Cash Flow

43 Pages Posted: 21 Feb 2008 Last revised: 12 Jul 2012

Jacob Oded

Tel Aviv University - Faculty of Management

Date Written: July 10, 2012

Abstract

This paper builds on the agency costs of free cash to explain how firms determine their payout policies. Payout methods considered are dividends and open-market stock repurchase programs. Dividends eliminate the agency costs of free cash by reducing cash under management (insiders) discretion, but could result in underinvestment if the paid out cash is needed later for operations. Stock repurchase programs avoid the underinvestment problem by giving insiders the option to cancel the payout. They are also an incentive to pay out cash because they provide trading gains to better informed insiders through the firm's informed trade. Because their execution is optional, however, repurchase programs cannot always prevent the waste of free cash. Payout policy is thus determined as a trade-off between eliminating agency problems with dividends and preserving financial flexibility with open-market programs.

Keywords: payout policy, dividends, repurchase

JEL Classification: G35, G30

Suggested Citation

Oded, Jacob, Payout Policy, Financial Flexibility, and Agency Costs of Free Cash Flow (July 10, 2012). Available at SSRN: https://ssrn.com/abstract=1096146 or http://dx.doi.org/10.2139/ssrn.1096146

Jacob Oded (Contact Author)

Tel Aviv University - Faculty of Management ( email )

Ramat Aviv
Tel-Aviv, 6997801
Israel

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