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

• DOI: http://doi.org/10.1111/jbfa.12407
• Published date: 01 January 2020
• Date: 01 January 2020
• Author: Jacob Oded

DOI: 10.1111/jbfa.12407

Payout policy, financial flexibility, and agency costs

of free cash flow

Jacob Oded

Coller School of Management, TelAviv

University, TelAviv, Israel

Correspondence

JacobOded, Coller School of Management,

TelAvivUniversity, TelAviv,69978, Israel.

Email:oded@post.tau.ac.il

Fundinginformation

TheHenry Crown Institute of Business Research

inIsrael; Israel Science Foundation; TevaPharma-

ceuticalIndustries

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 provid-

ing 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 preventthe waste of free cash. The model provides testable

predictionsthat 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

1INTRODUCTION

Payoutpolicy during the 1980s and 1990s was characterized by dramatic growth in repurchase activity and a decrease

in firms’ tendency to pay dividends.1Since the late 1990s, however,dividends and repurchases have had similar eco-

nomic significance, indicating both payout methods remain important (see, for example, Farre-Mensa, Michaely &

Schmalz, 2014). Extensive theoretical work has considered how firms choose between dividends and repurchases. The

vast majority of this literature uses taxesor a signaling framework. Interestingly, agency theories of free cash are stan-

dard in the capital-structure literature but are less common in the payoutliterature. We aim to fill this gap.

Empirically, problems associated with the disbursement of free cash through repurchases are well documented.

Many firms that announce repurchase programs eventually repurchase only part of what they announce, if at all,

1Onthe growth in repurchase during the 1980s–1990s, see, e.g., Grullon and Michaely (2002), and Boudoukh, Michaely,Richardson, and Roberts (2007). On

thedecrease in tendency to pay out dividends, see, for example, Floyd, Li, and Skinner (2015).

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2019 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:218–252.

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suggesting repurchases are not that efficient in paying out free cash (e.g., Stephens & Weisbach, 1998). Repurchases

also redistribute wealth among the shareholders wheneverthe stock is mispriced (e.g., Barclay & Smith, 1988; Brennan

& Thakor, 1990). Dividends are less subject to these drawbacksas they are relatively more committing and because

they are pro-rata. Dividends’ stronger commitment to payout comes at a cost, as it leaves management less freedom

to adjust payout to investment needs. Although firms can raise cash to compensate for the non-flexible nature of

dividends, issue costs tend to be high (e.g., Ross, Westerfield, & Jordan, 2008). Indeed, the importance of financial

flexibilityin payout policy is well documented (e.g., Brav, Graham, Harvey,& Michaely, 2005; Lee & Rui, 2007; Bonaime,

Hankins, & Harford, 2014; Iyer & Rao, 2017).

In this paper we consider payout policy as a trade-off between preserving financial flexibility and preventing the

waste of free cash, under asymmetric information. Forcing payout of cash can constrain the firm and result in under-

investment, while not forcing payout may result in overinvestment/free-cashwaste by self-interested managers. The

shareholders’ problem is thus how to get managers (insiders) to return cash to shareholders without hurting invest-

ment, when only the insiders get to see whether this cash is free or not. To deal with this problem, the shareholders

have several alternatives. They can choose not to payout any cash. In this case they accept the agency problem, but

make it less likely that investment will be shaved.Indeed, many firms do not pay out cash. These are usually growth

firms for which financial flexibilityis crucial and agency costs of free cash are low. If they do want to disburse free cash,

the shareholders can choose to pay dividends. Weview dividends as a predetermined p ayoutprogram, as they become

a commitment once declared by the board, and also informally commit the firm to future dividends. Another option

availableto the shareholders is to announce an open-market stock repurchase program (henceforth “open-market pro-

gram” or “repurchase program”or “repurchase”), which we view as a (costly) payout-incentivizing mechanism. Specifi-

cally,because an open-market program does not commit the firm to repurchase any shares, it leaves the management

(insiders) the option not to pay out the cash if the cash is later needed for operations. On the other hand, it can incen-

tivize payout when cash is not needed for operations by providing these better informed insiders with gains through

the firm’s informed repurchase trade that may outweigh their benefit from wasting free cash. The general sharehold-

ers lose from the adverse selection that the insiders’ informed tradeengenders, but at the same time they benefit from

preserving the firm’s financial flexibility and alleviatingthe problem of wasting of free cash.

Wedevelop a model of payout policy to support these arguments. In a two-period setup, the model considers a finan-

cially constrained firm that faces uncertainty about its investment needs. The firm is owned by general shareholders

(outsiders) and is run on their behalf by agents (insiders). These agents are shareholders too, but they also gain private

benefits from the waste of free cash. The outside shareholders dictate the firm’s payout policy (e.g. through its board,

shareholder meetings, and relationship investing) and choose among a dividend, a repurchase program, and no payout

in order to maximize their wealth. A dividend forces cash out of the firm immediately and therebyprevents the waste of

free cash, but may result in shaving of investment in the case where the investmentopportunity turns out to be large.

A repurchase program announcement delegates the decision whether or not to pay out cash to the insiders. Given a

repurchase program announcement, if the investmentopportunity is realized to be large, the firm has no free cash, and

hence the insiders will not executethe program. If the investment opportunity is realized to be small, the firm has free

cash that the insiders may waste if the stock is overvalued but will use to executethe repurchase through the finan-

cial markets if the stock is undervalued. Thus, while their informed trades on the firm’s behalf benefit the insiders at

the expense of the (uninformed) outside shareholders, the outside shareholders also benefit from preventing a waste

of cash. The payout policy set by outside shareholders is determined as an optimization (minimization) of investment

shaving, trading losses to the insiders, and free cash waste.

The analysis emphasizes two important properties of open-market programs that dividends do not share and

that may explain the role of these programs as a payout tool. First, the model builds and crucially depends on the

assumption that open-market programs are flexible while dividends are committed. That is, it assumes there is an

option not to repurchase, should the availability of free cash change while dividends must be paid once declared. This

assumption has strong support in the corporate world. Legally,the announcement of a program does not commit the

firm to repurchase any shares, while a dividend declarationis a firm commitment. There is also vast empirical evidence

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that firms only partly executetheir announced repurchase programs, if at all. Indeed, Netter and Mitchell (1989) report

that immediately after the market crash in October 1987, hundreds of companies announced a repurchase program,

but many of them did not repurchase any shares. Stephens and Weisbach (1998) find that in the US 5% of announced

programs are not executed at all, and that averageactual repurchase rates are only 70–80%. Outside the US, actual

repurchase rates are evenlower. Ikenberry, Lakonishok and Vermaelen(2000) find average actual repurchase rates to

be as low as 28% in Canada, Rau and Vermaelen(2002) find average actual repurchase rates of only 37% in the UK, and

Ginglinger and Hamon (2007) find only 10% in France.In their CFO survey, Brav et al. (2005) find that it is not unusual

for firms to announce that they will repurchase shares whenever the stock is undervalued, and they often state that

the repurchase program may be suspended or discontinued at anytime without prior notice.

At the same time there is strong empirical evidence that dividends are NOT flexible, and that firms smooth and

are reluctant to reduce or omit dividends. Lintner (1956) and Brav et al. (2005) find that managers consider main-

taining stable dividends a top priority and would pass on positive net present value (NPV) investment before cutting

dividends. Leary and Michaely (2011) find that the firms that smooth dividends the most are those most likely to be

subject to agency costs of free cash, consistent with the link between agency conflicts and inflexibility of dividends

that our model builds on. Other studies find that firms only omit dividends in the face of persistently anemic earnings

(e.g., Miller & Modigliani, 1961; Healy & Palepu, 1988; and Michaely,Thaler, & Womack, 1995). Dividend reductions

are relatively rare (e.g.,DeAngelo, DeAngelo, & Skinner, 2000) and stock market penalties for such reductions are well

documented (e.g., Aharony & Swary,1980; Healy & Palepu, 1988). There are no such penalties documented for repur-

chases (see Stephens & Weisbach, 1998). Indeed, industry trends suggest that modern corporations face an increas-

ing need for agility that dividends lack and open-market programs provide. This is generallythe case for hi-tech firms

because of their need for financial flexibility. Forexample, when Microsoft started to pay out cash, excluding a one-

time special dividend, the payout was designed to be executedprimarily through a four-year open-market repurchase

program rather than through dividends. Other maturing tech giants have followed this pattern (e.g. Intel, Apple, and

Qualcomm). Using the financial crisis period of 2008–2009, Iyer and Rao (2017) show that repurchasing firms scaled

down their payout in response to the crisis much more than dividend payers did, consistent with repurchases being

more flexible than dividends.

Second, the model results suggest that open-market programs stimulate the payoutof free cash by providing gains

to insiders through the firm’s informed trade. Repurchases may stimulate payout when outside shareholders who

worry about free cash waste are not powerful enough to impose payout in the form of dividends on insiders. Indeed,

firms often respond to shareholder activists’ demand for dividends with a willingness to initiate share repurchase pro-

grams (e.g. Carl Ichan with Apple and Harry Wilson with General Motors). Given the increasing cash holdings of cor-

porations and the declining propensity of firms to pay dividends, our findings suggest that open-marketprograms may

haveevolved as a mechanism that motivates payout when dividends would constrain the firm, or are hard to impose on

self-interested insiders.2

While informed trade has severalpositive externalities, from more efficient price formation to better resource allo-

cation, the repurchase literature, has generallyfocused on the wealth transfer associated with it that adversely affects

uninformed investors (e.g.,Barclay & Smith, 1988; Brennan & Thakor, 1990). Our novel contribution is in showing how

this informed trade from the firm side can also benefit the uninformed, and in demonstrating the manner in which this

feature may shape the firm’s choice between dividends and repurchase. Specifically, we suggest repurchases’ wealth

redistribution property can serve as an incentive to disburse cash exactly when the cash is not needed for investment

(when the cash is free), and is more likely to otherwise be wasted. More generally,the wealth redistribution property

can help align the actions of the agent (insiders) with the interests of the general shareholders. That is, we suggest

that the wealth redistribution does not represent a zero-sum game. In the presence of agency costs of free cash and

2Cashholdings of US companies reached $1.9 trillion in 2016, up from$0.74 trillion in 2006. (See, S&P Global May 25, 2017, “US corporate cash reaches $1.9

trillionbut rising debt and tax reform pose risk⋅”.) On the importance of optimizing the firm’s cash holdings see, for example, Almeida, Campello, and Weisbach

(2004).