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

44 Pages Posted: 21 Feb 2008 Last revised: 28 Sep 2017

Jacob Oded

Tel Aviv University - Faculty of Management

Date Written: September 27, 2017

Abstract

Informed trade is generally viewed negatively in financial markets. Indeed, it transfers wealth from uninformed to informed shareholders, impairs market efficiency, discourages trade, and thereby reduces social wealth. In this paper we suggest that informed trade can also have positive features. Specifically, we consider the informed trade associated with open-market repurchase programs, the prevailing method that firms use to disburse cash today. We show that when agency costs of free cash are an issue, personal gains to informed insiders associated with the firms’ repurchase trade can stimulate free cash disbursement. Thus, at the cost of trading gains to informed insiders at the expense of uninformed shareholders, higher benefits from free cash waste prevention are obtained for the uninformed shareholders. Unlike the case of dividend payout, the execution of open market programs is optional, and hence they cannot completely prevent the waste of free cash. Relative to dividends, however, open-market programs avoid underinvestment by leaving insiders the option to cancel the payout when the firm is cash constrained. We demonstrate the implications of this result on a firm’s choice between dividends and repurchases. The model provides testable predictions that are generally consistent with the empirical evidence.

Keywords: payout policy; stock repurchases; dividends; informed trade; agency costs of free cash

JEL Classification: G14, G30, G35

Suggested Citation

Oded, Jacob, Payout Policy, Financial Flexibility, and Agency Costs of Free Cash Flow (September 27, 2017). 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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