Payout and Investment Decisions Under Managerial Discretion

Abstract

In traditional signalling models, high-quality firms can separate themselves from low-quality firms by using their payout policy. Standard agency theory suggests that shareholders will pressure managers to pay out all excess cash in order to avoid overinvestment.

If firms have different investment opportunities, and these investment opportunities are imperfectly known to investors, signalling a la Miller and Rock (1985) does not work. Moreover, since the actual amount of excess cash is difficult to determine, attempting to induce management to disburse cash can leave the firm with either too much or too little cash available for investment.

The paper examines a framework where managers' incentives are not necessarily aligned with those of the shareholders, and where the investment opportunities of various firms are different and not known by investors. As a result, dividends become an imperfect indicator of firm quality. Looking at payout policy from this angle allows us to explain and reconcile several empirical regularities found in the literature. The role of informed investors, active shareholders and repurchases is also discussed.

Keywords: Payout policy, investment policy, asymmetric information, dividends, repurchases, catering

JEL Classification: G35