Payout policy is about finishing the job. Investors put their money in the firm wishing for maximum return on their investment. As long as the money is needed for the firm’s growth, they would optimally want it to stay in the firm. Should they have liquidity needs during the growth period, they can sell shares and, assuming financial markets function well, get their fair value. Insiders receive the cash from the investors (the shareholders), and as long as expected return on investment is high, their interest is aligned with the interest of the shareholders.
This is both because often they are shareholders themselves and because they get compensated by the general shareholders for the growth. Sooner or later, however, the firm matures and return on initial investment and on cash generated by the firm and reinvested decreases significantly. At that point, the shareholders’ interest is that the firm will finish the job. I.e. that free cash, cash that is not needed/cannot support growth any more, would be paid out.
They will then put it in new ventures where more favorable returns are available. However, they face two problems in getting the insiders finish the job. First, when the growth slows, the insiders’ interest is no longer aligned with the general shareholders interest. Specifically, although return on investment to the firm is decreasing, the value of perks to insiders associated with the investment is not. (E.g. the manager’s benefit from a private jet is high whether or not this jet is still needed to support a high growth rate.) Thus, the shareholders face an agency problem. So why don’t the shareholders force the cash out at this point? Because there is also an information problem: insiders observe when the growth slowed down first.
Only later do the general shareholders receive the information. When coming to deal with these agency and information problems the shareholders have several alternatives. One is to do nothing, i.e. let insiders do as they please. Another alternative is to force the cash out according to a pre-determined program.
The first alternative is accepting the agency problem. The second reduces the agency problem but creates a potentially more severe one. This is because forcing the cash out according to a predetermined program may severely hurt return by shaving investment. Specifically, if cash is forced out too early, when it is still needed to support growth, the damage to the firm and hence to shareholders value can be even more severe. (E.g. what if the manager is forced to sell the jet when his mobility is still needed to assure the success of the project?) There is one more thing the shareholders can do. Instead of forcing the cash out, they can look for mechanisms that will incentivise insiders to pay the cash out once it is not needed for operations any more. Of course, incentives are costly too, but their cost may be lower than the agency costs of free cash and the costs of shaving investment.
The purpose of this paper is to explain payout policy as a trade-off between preventing the waste of free cash and preserving financial flexibility. Specifically, forcing cash out may result in under-investment whereas not forcing the cash out may result in over-investment. The shareholders’ problem is thus how to get managers (insiders) finish the job and return cash to investors without hurting investment when only the management gets to observe whether this cash is free or not.
The “do nothing” alternative is having no payout policy at all. Many firms do not pay out cash and find this to be the optimal strategy. They of course accept the agency problem but guarantee that investment will not be shaved, at least as far as the firm’s budget allows. These are usually growth firms for which on the one hand financial flexibility is crucial and on the other hand agency costs of free cash are low. Dividend, we suggest, is the predetermined payout program alternative. Dividends become a commitment once declared by the board. They are generally paid immediately (within few weeks) and informally commit the firm for future dividends. Indeed, the empirical evidence suggests that dividends are sticky regardless of the investment prospects (Lintner 1956). Thus, firms that pay dividend may need to shave investment.
Dividend paying firms, however, are generally mature firms for which it is relatively easy to predict how much cash is needed to support growth and operations, and what portion of the cash they generate is free. In these firms the benefits from reducing the agency costs of free cash with a pre-determined program are significantly higher than the expected costs from reducing financial flexibility by pre-committing to a payout. An open-market repurchase program, we suggest, is the (costly) payout incentivising mechanism. Specifically, an open-market program leaves the management (insiders) the option not to pay out the cash when the cash is needed for operations. On the other hand, it incentivises payout when cash is not needed for operations by providing these better informed insiders with trading gains that replace their benefit from wasting free cash. The general shareholders lose from the insiders’ informed trade, but at the same time they benefit from preserving financial flexibility and alleviating the free-cash-waste problem, although not completely eliminating it.
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