Payout policy, financial flexibility, and agency costs of free cash flow

Jacob Oded*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

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.

Original languageEnglish
Pages (from-to)218-252
Number of pages35
JournalJournal of Business Finance and Accounting
Volume47
Issue number1-2
DOIs
StatePublished - 1 Jan 2020

Keywords

  • G14
  • G30
  • G35
  • agency costs of free cash
  • dividends
  • informed trade
  • payout policy
  • stock repurchases

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