Investment, Dividends, Firm Performance and Managerial Incentives: The 'Tradeoff Model'
41 Pages Posted: 18 Dec 2008 Last revised: 30 Mar 2011
Date Written: December 14, 2008
We develop a model, the "Tradeoff Model", to identify the nature of the agency costs of free cash flows in practice and the role of managerial incentives in mitigating these costs. Using US based data; we find empirical evidence that managers make a tradeoff when they allocate the cash flow of the firm between investment and dividends. Managers underinvest and overpay dividends when offered short-term incentives, like bonuses and vested stocks. Managers overinvest and underpay dividends when offered long-term incentives, like unvested stocks and options. An increase in these incentives would retract investment and dividends toward the optimal levels, thus firm performance would improve. Moreover, we find concave relations between investment and both bonus and option incentives, and corresponding convex relations between dividends and these two incentive schemes, confirming the tradeoff made by managers between investment and dividends. We also find concave relations between firm performance and all incentives, except option incentives where the relation is convex.
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