Payout Policy, Financial Flexibility, and Agency Costs of Free Cash Flow
35 Pages Posted: 27 May 2020
Date Written: January/February 2020
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: Suggested Citation