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

35 Pages Posted: 27 May 2020

See all articles by Jacob Oded

Jacob Oded

Tel Aviv University - Coller School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: January/February 2020

Abstract

This paper explains how firms choose between dividends and open‐market repurchase programs, the prevailing method that firms use to disburse cash today. While earlier theories about payout policy are motivated by signaling, the motivation for payout in this paper is to prevent the waste of free cash by self‐interested insiders. In the model, dividends prevent free cash waste by forcing cash out, but result in underinvestment if the cash paid out is later needed for operations. Open‐market programs stimulate payout by providing personal gains to informed insiders that are associated with the firm's repurchase trade. Yet, they also avoid the underinvestment problem by leaving insiders the option to cancel the payout. Because their execution is optional, however, open‐market programs only partially prevent the waste of free cash. The model provides testable predictions that are generally consistent with the empirical evidence.

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

JEL Classification: G14, G30, G35

Suggested Citation

Oded, Jacob, Payout Policy, Financial Flexibility, and Agency Costs of Free Cash Flow (January/February 2020). Journal of Business Finance & Accounting, Vol. 47, Issue 1-2, pp. 218-252, 2020, Available at SSRN: https://ssrn.com/abstract=3604494 or http://dx.doi.org/10.1111/jbfa.12407

Jacob Oded (Contact Author)

Tel Aviv University - Coller School of Management ( email )

Ramat Aviv
Tel-Aviv, 6997801
Israel

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