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Dividend policy, signalling and free cash flow: an integrated approach

Richard Fairchild
School of Management, University of Bath, Bath, UK
Abstract
Purpose Scholars have examined the importance of a firms dividend policy through two competing paradigms: the signalling hypothesis and the free cash-flow hypothesis. It has been argued that our understanding of dividend policy is hindered by the lack of a model that integrates the two hypotheses. The purpose of this paper is to address this by developing a theoretical dividend model that combines the signalling and free cash-flow motives. The objective of the analysis is to shed light on the complex relationship between dividend policy, managerial incentives and firm value. Design/methodology/approach In order to consider the complex nature of dividend policy, a dividend signalling game is developed, in which managers possess more information than investors about the quality of the firm (asymmetric information), and may invest in value-reducing projects (moral hazard). Hence, the model combines signalling and free cash-flow motives for dividends. Furthermore, managerial communication and reputation effects are incorporated into the model. Findings Of particular interest is the case where a firm may need to cut dividends in order to invest in a new value-creating project, but where the firm will be punished by the market, since investors are behaviourally conditioned to believe that dividend cuts are bad news. This may result in firms refusing to cut dividends, hence passing up good projects. This paper demonstrates that managerial communication to investors about the reasons for the dividend cut, supported by managerial reputation effects, may mitigate this problem. Real world examples are provided to illustrate the complexity of dividend policy. Originality/value This work has been inspired by, and develops that of Fuller and Thakor, and Fuller and Blau, which considers the signalling and free cash-flow motives for dividends. Whereas those authors consider the case where firms only have new negative net present value (NPV) projects available (so that dividend increases provide unambiguously positive signals to the market in both the signalling and free cash-flow cases), in this papers model, the signals may be ambiguous, since firms may need to cut dividends to take positive NPV projects. Hence, the model assists in understanding the complexity of dividend policy. Keywords Dividends, Corporate finances, Cash flow Paper type Research paper

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1. Introduction Nearly 50 years after Miller and Modiglianis (1961) famous dividend irrelevance theorem, academics and practitioners still have little understanding of dividend policy and its effect on firm value. Indeed, Black (1976) observed, The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just dont fit together. In this paper, we develop a dividend signalling model that attempts to analyse the various factors that affect dividend policy and firm value. According to Miller and Modiglianis (1961) theorem, the value of the firm is unaffected by its dividend policy in a world of perfect market conditions. Two major assumptions driving the MM irrelevance theorem were that:
Managerial Finance Vol. 36 No. 5, 2010 pp. 394-413 # Emerald Group Publishing Limited 0307-4358 DOI 10.1108/03074351011039427

(1) A firms management is purely interested in maximizing share-holder value (there are no agency problems). (2) Corporate insiders and outsiders share the same information about the firms operations and prospects (the symmetric information assumption).

Subsequent theoretical research has analysed the effects of incorporating asymmetric information and agency problems into the firms dividend decision. This resulted in two competing approaches; the dividend signalling hypothesis, and the excess cash hypothesis. Our dividend model incorporates both approaches. The signalling hypothesis states that under asymmetric information between managers and investors, dividend policy may provide signals regarding the firms current performance and future prospects[1]. The free cash-flow hypothesis (also known as the excess-cash hypothesis) states that dividend policies address agency problems between managers and outside investors (for example Easterbrook, 1984; Jensen, 1986; Fluck, 1995). In particular, the agency problem in Jensens (1986) analysis arises from an empire building managers incentives to invest in negative net present value (NPV) projects. Dividends alleviate this problem by reducing the free cash flow available to the manager. As noted by Fuller and Thakor (2002), both of these hypotheses (signalling and free cash flow) support much (but not all) of the empirical evidence that dividend increases (decreases) are good (bad) news, causing stock price increases (decreases). Perhaps the reason why a solution to Blacks (1976) dividend puzzle remains so elusive is that we lack an integrated theory that incorporates both the signalling and free cash-flow motivations for dividends (Fuller and Thakor 2002; Fuller and Blau, 2010). Fuller and Thakor (2002) sketch the first such integrated model. We build on their work by developing a dividend model that incorporates both asymmetric information and free cash-flow problems. Particularly, we consider a dual role for dividends. Dividends may provide a signal of current income to investors (hence the manager is motivated to choose a high dividend to provide a positive signal). However, in our analysis, a new project is available to the firm. If the firm wishes to invest in this project, it must get the funds from current income. Hence, in addition to the current income-signalling role, the level of dividends may also affect the managers ability to invest in the new project. Hence, the manager may wish to cut dividends (to take a good, value-adding project), or he may wish to payout high dividends (to reduce the free cash flow in order to commit not to take a bad, value-reducing project). Our model contributes to Fuller and Thakors (FT 2002) analysis in the following ways. First, we develop the analysis, and derive the equilibria of the dividend game, in a formal and rigorous manner[2]. Second, FT only consider the possibility that a negative NPV project exists. Hence, they focus on Jensens (1986) free cash-flow problem. In contrast, we consider the possibility that the project may have a negative or positive NPV. This enables us to consider the following under-researched area. Although the majority of theoretical and empirical work suggests that the relationship between dividends and share price is positive (dividend increases are good news), Wooldridge and Ghosh (1998) have suggested that, when a firm has strong growth opportunities available, dividend cuts may not always be bad news. Conversely, dividend increases may be bad news. For example, Allen and Michaely (2002) argue, However, we note that with asymmetric information, dividends can also be viewed as bad news. Firms that pay dividends are the ones that have no positive NPV projects in which to invest, and according to Black (1976), Perhaps a corporation that pays no dividends is demonstrating confidence that it has attractive investment opportunities that might be missed if it paid dividends. Hence, the relationship between dividends and firm value is complex. The market may view an increase in dividends favourably, either as a positive signal of current income (that is dividends reduce asymmetric information problems), or as a means of

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mitigating free cash-flow problems (that is dividends reduce agency problems). However, a dividend increase may be seen as a negative signal (the firm lacks growth opportunities), while a dividend cut may be seen as a positive signal (the firm has significant growth opportunities available). Our integrated signalling/excess cash-flow model of dividends attempts to analyse all of these affects. Our third contribution is to consider two types of inefficiency (or agency problem) relating to managerial incentives regarding dividend policy[3]. Firstly, we analyse a moral hazard problem in which empire-building managers may cut dividends in order to invest in a negative (value-reducing) NPV project due to managerial private benefits. Secondly, we consider an adverse selection problem, whereby managers may refuse to cut dividends, hence passing up a positive NPV project[4]. Indeed, Cohen and Yagil (2006) identify a new type of agency cost of dividend: the sum of positive NPV projects that are abandoned in order to pay dividends. Frankfurter and Wood (2002) observe that, in addition to analysing the effects of agency and asymmetric information problems on dividend policy, researchers are beginning to consider behavioural models. They observe that,
Investor behavior is substantially influenced by societal norms and attitudes [. . .]. According to Shiller (1989), including these influences in modeling efforts can enrich the development of a theory to explain the endurance of corporate dividend policy.

Our fourth contribution is that we include a behavioural dimension in our model. That is, we consider investors who have been conditioned to believe that high dividends signal high quality[5]. In our first case, the investors beliefs are indeed correct, as the high-quality firm can separate from the low-quality firm by paying a high dividend. In the second case, these beliefs drive the adverse selection problem (the high-quality firm is unwilling to reduce the dividend below that of the low-quality firm, since the market then mistakenly values this firm as low quality)[6]. As an extension to our second case, we consider whether the adverse selection problem can be mitigated by communication to investors, reinforced by managerial reputation effects. Indeed, Wooldridge and Ghosh (1998) argue that firms may be able to avoid a negative market reaction by communicating to investors that the reason for dividend cuts is to invest in future growth opportunities. It may be argued that this may be cheap-talk. However, Wooldridge and Ghosh argue that managerial reputation may provide an important mechanism for providing credibility to corporate finance decisions. The role of reputation in dividend policy has been explored by Brucato and Smith (1997) and Gillet et al. (2008). In Brucato and Smith, a reputable dividend signal is one where an unexpected dividend increase is confirmed by a subsequent unexpected earnings increase. Similarly, in Gillet et al., the reputation mechanism is such that the market punishes a firm that chooses a high dividend (in order to fool the market that it is a high-income firm), but subsequently reports low profitability. In contrast, in our model, we consider the role of managerial reputation in allowing a firm to communicate that it is cutting the dividend in order to invest in a new value-adding project. The remainder of the paper is organized as follows. In section 2, we present our model. In section 2.1, we consider our free cash-flow case. In section 2.2, we consider our adverse selection case, and consider the role of communication and reputation. In section 4, we discuss practical and managerial implications of our model. Furthermore, in the light of our model, we consider some anecdotal evidence demonstrating the complexities surrounding dividend policy. Section 5 concludes.

2. The model We consider an economy consisting of two all-equity firms[7] and a capital market. There is universal risk neutrality, and the risk-free rate is zero[8]. Firm i is run by manager i 2 G, B (for good and bad, respectively[9]). The timing of events is as follows. Each firm enters the game with existing net income of Ni, with Ng > Nb > 0. At the start of the game, the market cannot observe managerial type, and, in the absence of signals, assigns an equal probability to each firm being of each type. At the end of date 0, firm is net income Ni is revealed to manager i, but not to the investors. The market becomes aware of a future investment opportunity (a new project, denoted project n). Furthermore, the market knows that this project will achieve a date 2 return on equity . At date 1, each manager i makes a committed dividend announcement (that is, he announces a payout of Di, to which he is committed). The two managers make these announcements simultaneously. The announcement has a signalling role (to be described below), which affects firm value. At this stage, the manager receives monetary compensation, as a fraction  2 [0, 1] of the date 1 firm value V1. Hence, dividend signalling is important to the manager, since it affects date 1 firm value, and, therefore affects managerial compensation. At date 1.5, each manager pays out the dividend that was announced at date 1. The subsequent investment opportunity, project n, requires investment I 2 (Nb, Ng]. If a manager has sufficient date 1 cash flow remaining (after paying the dividend), he is able to invest in the new project[10]. Therefore, manager B is unable to invest in project n, regardless of his level of dividend payout, since Nb < I. Manager G is able to invest in the new project if Ng Dg  I >Ng I  Dg. Alternatively, a manager can invest in financial securities at zero NPV. At date 2, if project 2 has been taken, it provides private benefits[11] to the manager of b > 0, and it achieves net income I(1 ) in date 2. We consider two possibilities; I(1 )  0 (project 2 has positive or zero NPV), and I(1 ) < 0 (project 2 has negative NPV). All of the date 2 net income is paid out as date 2 dividend, and the game ends. We note that, since the manager has already received his monetary compensation at date 1, he will invest in the new project at date 1.5 if he can (regardless of whether I(1 )  0 or I(1 ) < 0) in order to obtain the private benefits b > 0. This provides a possible moral hazard problem, and provides a potential role for dividends as a commitment device not to take negative NPV projects (as in Jensen, 1986). The manager has a date 1 compensation scheme, M  V1 B 1

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where  2 [0, 1] represents the managers compensation parameter (or equity stake), V1 is the managers date 1 monetary compensation, and B 2 b, 0 are the date 2 private benefits if the manager does or does not take project 2, respectively. The managers objective is to choose dividends to maximize M given the other managers choice of dividends. We consider two cases; (a) Ng I > Nb (see section 2.1), and (b) Ng I < Nb (see section 2.2). In the first case (Ng I > Nb), we consider a situation where the high-quality (highincome) firm can separate from the low-quality (low-income) firm by setting a higher dividend, and still be able to set a sufficiently low dividend to invest in the new project if it wishes to. Therefore, dividends can solve the asymmetric information problem

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(that is, they can be used to signal current income). In this case, we focus on the role of dividends in mitigating the agency problems of free cash flow. In the second case (Ng I < Nb), we consider an adverse selection problem, where the high-quality firm cannot simultaneously cut dividends to invest in a new positive NPV project, and separate from the low-quality firm. That is, since Ng I < Nb, the bad firm can mimic the good firms dividend if the good firm cuts the dividend to invest in the new project. In this case, we consider the role of communication and managerial reputation. 2.1 Dividends as an unambiguous signal of quality (Ng I > Nb) Since Ng I > Nb, manager g is able to invest in the new project, and still separate from manager b by choosing a dividend in excess of Nb (which manager b cannot mimic). Note that this case allows us to focus our attention on the role of dividends in mitigating the agency problems of free cash flow. We restrict our attention to the following dividend choices. Manager B can only choose[12] Db Nb. Manager G can choose a dividend D 2 Nb, Ng I, Ng. By restricting our attention to these choices, we are able to consider the case where:
. .

manager G pays the same dividend as manager B; manager G pays a higher dividend than manager B, and is able to invest in the new project; or manager G pays a higher dividend than manager B, and is unable to invest in the new project.

In order to solve for the Bayesian equilibria of the dividend-signalling game, we need to specify how the market updates its beliefs upon observing the managers dividend choices[13]. We specify the following posterior beliefs. If both managers chose the same dividend, the market cannot update its beliefs. If one manager chooses a higher dividend than the other, the market believes that the manager who has chosen the higher (lower) dividend is the good (bad) manager[14]. In P1, we consider the effect of the new projects return on equity  (which determines whether project 2 has positive or negative NPV) and the managers private benefits on the equilibrium dividend policies (we relegate all proofs to the Appendix). P1. We take as given that investors believe that a high/low dividend combination signals a high-/low-quality firm. In the case that the difference between the high- and low-quality firm is sufficiently large (equivalently, the required investment for the new project is relatively small), Ng I > Nb the highquality firm can separate from the low-quality firm by paying a higher dividend, and still invest in the new project if it wishes. P1a. In the case that the new project has a positive NPV (  0), a separating equilibrium exists where the good manager chooses medium dividend level Dg Ng I, while the bad manager chooses low dividend level Db Nb. This enables the good manager to separate from the bad manager by paying a higher dividend, while retaining enough cash to invest in the new project. P1b. If the new project has a negative NPV ( < 0), and the managers compensation plus private benefits from the new project are positive (I b  0), a separating equilibrium exists where the good manager

chooses medium dividend level Dg Ng I, while the bad manager chooses low dividend level Db Nb. The good manager separates from the bad manager by paying medium dividends, and invests in the negative NPV project due to managerial private benefits (moral hazard problem). P1c. If the new project has a negative NPV ( < 0), and the managers compensation plus private benefits from the new project are negative (I b < 0), a separating equilibrium exists where the good manager chooses high dividend level Dg Ng, while the bad manager chooses low dividend level Db Nb. The good manager separates from the bad manager by paying high dividends, and commits to the market not to invest in the negative NPV project (using dividends to mitigate the moral hazard problem). Proof. See the Appendix. 2.1.1 Cross-sectional effect of dividends on firm value. Fuller and Thakor (FT 2002), and Fuller and Blau (2010), suggest that the cross-sectional relationship (that is across firms) between dividends and firm value may be complex and non-monotonic. In this section, we demonstrate that the results in P1 support FTs hypothesis. Figure 1 depicts the results in P1. The diagram considers a cross-section of firms, and demonstrates that the relationship between dividends and firm value may be monotonic, or non-monotonic (as in FT 2002). Interval A represents firms run by B-type managers who pay the lowest dividend, and hence have the lowest firm value. Interval C represents firms run by G type managers, for whom I b < 0; managerial compensation is such that these managers choose the highest dividend to a) signal high current income, and b) commit to the market not to invest in the new negative NPV project. Interval B represents firms run by G type managers, for whom I b  0; managerial compensation is such that these managers choose a medium level of dividends in order to invest in the new project. Now, if the new project has negative NPV, firm value for these firms will be less than those in interval A or C (monotonic

Dividend policy, signalling and free cash flow 399

Figure 1.
Cross-sectional relationship between dividends and firm value

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relationship). However, if the new project has a positive NPV, firm value for these firms will be higher than those in interval A or C (non-monotonic relationship). 2.2 Numerical example We illustrate this case by way of a numerical example with the following parameter values: Ng 400, Nb 100 and I 200. Since Ng I > Nb, manager G is able to cut dividends to invest in the new project, and separate from manager B by paying a higher dividend. As noted in P1, when the project has positive NPV, manager G will pay the medium dividend to invest in the new project while separating from manager B. When the project has negative NPV, manager Gs incentive to pay the medium dividend (to invest in the new project) or the high dividend (to commit not to take the new project) depends on his equity compensation and his private benefits. In order to examine this, we consider the case where the managerial compensation (equity) parameter is  0.5. Furthermore, we consider two possibilities for managerial private benefits from investing in the new project; b 2 0.50. We consider two possibilities for the return on the new project;  10 per cent (positive NPV), and  10 per cent (negative NPV).
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When the project has a positive NPV, P1a revealed that manager G chooses the medium dividend Dg Ng I 200 to invest in the new project. Firm value is V Ng I 400 0.1(200) 420. If the new project has a negative NPV, P1b revealed that manager G chooses the medium dividend Dg Ng I 200 to invest in the new project if I b  0. This is indeed the case in our example with b 50. Firm value is V Ng I 400 0.1(200) 380. If the new project has a negative NPV and b 0, then manager G pays the high dividend Dg Ng 400 to commit not to take the new project (see P1c). Firm value is V Ng 400.

In all cases, Db Nb 100, and firm value is Vb 100. For clarity, we have inserted these numerical values into Figure 1. 2.3 Dividends as an ambiguous signal of quality: Ng I < Nb In our second case, we focus on the case where  > 0 (new project has positive NPV), and B 0 (the manager has zero private benefits). In contrast to the previous case, we focus on the agency problems associated with a manager refusing to cut the dividend, thereby passing up a positive NPV project (see Cohen and Yagil, 2006). We consider the following possible dividend levels; Di 2 Ng I, Nb, Ng. That is, if manager G chooses low dividend Ng I in order to invest in the new project, manager B can mimic him. We specify the following market beliefs:
.

If the market observes that both firms have chosen the same dividend level, the market is unable to update its beliefs, and continues to assign an equal probability to the firms being g or b. If the market observes that Di Nb, with Dj Ng I, the market believes that firm i is the good firm, and firm b is the bad firm. Hence, the market has been conditioned to believe that high dividends signal high quality.

If the market observes that Di Ng, with Dj Nb, or Dj Ng I, the market (correctly) believes that firm i is the good firm (since firm B cannot afford to payout Ng), and firm j is the bad firm.

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Using these beliefs, we derive the following equilibria (see the Appendix for the proof). P2. We take as given that investors believe that a high/low dividend combination signals a high-/low-quality firm. In the case that the difference between the high-quality and low-quality firm is low (equivalently, the required investment for the new project is relatively large), Ng I < Nb, the high-quality firm cannot cut the dividend to take the new project, and, at the same time, separate from the low-quality firm by paying a higher dividend. P2a. If the new projects positive NPV exceeds the negative adverse selection effect (I > Ng Nb), two equilibria exist: (i) a pooling equilibrium where both managers pay the low dividend; Dg Db Ng I, and (ii) a separating equilibrium where the good manager chooses the high dividend Dg Ng and the bad manager chooses the medium dividend Db Ng I. In (i), manager G cuts the dividend in order to invest in the new project. Manager B mimics manager Gs dividend choice, but is unable to invest in the new project. In (ii), manager G refuses to cut the dividend to take the new project, thereby passing up a good positive NPV investment opportunity. P2b. If the negative adverse selection effect exceeds the new projects positive NPV (I < Ng Nb), a separating equilibrium exists where the good manager chooses the high dividend Dg Ng and the bad manager chooses the medium dividend Db Nb. Manager G refuses to cut the dividend to take the new project, thereby passing up a good positive NPV investment opportunity. Proof. See the Appendix. For the remainder of this analysis, we focus on P2b; that is, manager G refuses to cut the dividend in order to invest in a positive NPV project, due to the adverse selection effect (manager B would mimic the low dividend). We now consider the role of corporate communication and reputation in enabling the good manager to cut the dividend in order to invest in the new project. First, we note that P2 is supported by irrational/behavioural beliefs. That is, the market has been conditioned to believe that higher quality firms pay higher dividends: we could appeal to catering theory (Baker and Wurgler, 2004), where investors may irrationally believe that the best firms pay dividends. Therefore, manager G refuses to cut dividends, passing up a positive NPV project. We now develop the game to incorporate corporate communication and reputation at the date 1 dividend announcement stage. Specifically, if manager i announces a dividend of Di Ng I, the market is unsure whether this represents the low-income firm, or the high-income firm cutting the dividend in order to invest in the new positive NPV project. At this stage, the manager can communicate (at zero cost) to the market that it is the good firm, and that he has set the low dividend in order to invest in the new project (and not because it has low current income).

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At date 2, the market observes firm type. The manager that has communicated and lied (manager b) suffers a reputation loss r. For example, Appendix equation (A.2) becomes B Ng Nb I =2 r : That is, the bad manager mimics the good manager by choosing Di Ng I, so that he achieves a pooled compensation at date 1, but then suffers a reputation loss r when his type is revealed at date 2[15]. We focus on the case where the reputation effect is strong enough for the good manager to be able to cut the dividend without fear of manager B mimicking; that is, we assume that[16] r > Ng Nb =2 I : We obtain the following result. P3. Consider the case where the negative adverse selection effect exceeds the new projects positive NPV (I < Ng Nb), such that the good manager refuses to cut the dividend to invest in the new project. Now allow the manager to educate, and communicate to, the market that dividend cuts are to invest in new positive NPV projects, thus altering the markets posterior beliefs. Given that r > Ng Nb =2 I (the reputation effect is sufficiently strong to prevent the bad manager from mimicking), the separating equilibrium is Dg* Ng I, and Db* Nb > Dg*. The good manager chooses the low dividend in order to invest in the new project, and the bad manager chooses the medium dividend. Proof. See the Appendix. 2.2.1 Cross-sectional Effect of dividends on firm value The cross-sectional effect of dividends on firm value is demonstrated in Figure 2. Figure 2 demonstrates that, if manager G can credibly communicate that he has cut the dividend in order to invest in the new project, the cross-sectional relationship between dividends and firm value may be negative. 3. Extension to model: repeated dividend game[17] Thus far in the analysis, we have taken the investors beliefs as exogenously given (that is, we assume that investors believe that a high/low dividend combination signals a high-/low-quality firm: see P1 and P2). Furthermore, we have focused on a static, oneshot, dividend choice, thereby examining the cross-sectional effect of dividends on valuation cross firms. In this section, we consider a repeated dividend game which seeks to explain how investors beliefs (that high/low dividends signal high-/low-quality firms) may be

Figure 2. Cross-sectional relationship between dividends and firm value when managerial communication is credible

formed over time. In order to do so, we focus on dividends as an ambiguous signal of quality (see section 2.2, where Ng I < Nb). Furthermore, we focus on P2b, where the negative adverse selection effect exceeds the new projects positive NPV (see P2b, where I < Ng Nb). Recall that this means that, if the investors have been conditioned over time to believe that high/low dividends signal high-/low-quality firms, then, in the absence of reputation or communication, the manager of the good firm will refuse to cut dividends to take the new project. This provides the interest in our repeated dividend game. To keep the analysis as simple as possible, our repeated dividend game consists of two stages. Furthermore, we incorporate the following behavioural factor. At the start of stage 1, neither of the firms (or the market) realize that the game will enter a second stage (the managers of the firms suffer from myopia/bounded rationality). Under this assumption, we can solve stage 1 before considering stage 2[18]. Furthermore, at stage 1, the new investment opportunity does not exist (therefore, investors are unaware that dividend policy may affect future investment and growth). In the first stage, our two firms (high and low quality) achieve a stage 1 income Ng and Nb, respectively. The market cannot observe these firm types. In the absence of signals, the market assigns equal probability to these types. At date 0 of stage 1, firm G and firm B simultaneously announce whether they will pay a high or low dividend; Di 2 Ng,Nb. As in our previous analysis, a firm cannot pay more than its stage 1 income (see[10]). The market updates its beliefs about firm type. We specify that the market believes that a high/low combination signals a high-/lowquality firm (this is not an assumption: see[13]). At date 1 of stage 1, the market observes firm income, and investors receive the first stage dividends. Before considering the second stage of the game, we solve for stage 1. The managers simultaneously choose dividends Di 2 Nb,Ng to maximize the managerial payoff: M  V1 2

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Since a firm cannot pay more than its current income as dividends, we only need to consider two possibilities: (1) both firms pay the same dividend; Di 2 Nb,Nb; and (2) the good firm pays a higher dividend than the bad firm; Db Nb, Dg Ng. Given the market beliefs that high (low) dividends signal a good (bad) firm, if both choose Di 2 Nb, Nb, then MG MB  Ng Nb 2 3

If the bad firm chooses Db Nb, and good firm chooses Dg Ng, then MB Nb MG  N g 4 5

Comparing (5) and (3), it is trivial to note that it is optimal for firm G to choose the high dividend to separate from firm B, who is restricted to the low dividend. Hence, in the

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(separating) equilibrium, the stage 1 dividends are Db Nb, Dg Ng. The market updates its beliefs, and the stage 1 firm values become VB Nb, VG Ng. Finally, at the end of stage 1, the market observes firm Gs and firm Bs income, and investors beliefs (that a high/low dividend combination signals a high-/low-quality firm) are confirmed. We take these beliefs into the second stage of the game, as described below. We now enter stage 2 of the game. Stage 2 is identical to the model described at the start of section 2 (the model). At stage 2, the firms realize that they are operating for a second period. Furthermore, at this stage, they become aware of the new investment opportunity. At this stage, we introduce a further behavioural factor. The market forgets which firm is type G or type B (otherwise there is no role for dividend signalling in stage 2), but remembers that the better firm paid the higher dividend. Investors take this belief into stage 2 (therefore, investors have been conditioned to believe that higher dividends signal higher quality). As noted, we focus on the adverse selection problem, where, in the absence of communication or reputation, the high-quality manager refuses to cut the dividend to take the new project (P2b). Effectively, dividends have become sticky. Since investors have been conditioned, by past performance and past dividend policy, to believe that high dividends signal a high-quality firm, the good manager refuses to cut dividends to invest in growth[19]. Now, reputation and communication become important (as in P3). 4. Practical and managerial implications Our dividend signalling model demonstrates that dividend policy is indeed complex. We have demonstrated that high dividends may have a positive effect on firm value, both by providing a positive signal of current performance (in terms of current income), and in reducing the free cash-flow problem (that is, the temptation for the manager to invest in negative NPV projects due to private benefits). However, when good positive NPV investment opportunities are available, a high dividend may indeed be value reducing if it prevents firms from being able to make these investments[20]. However, management may refuse to cut dividends, thereby passing up these positive NPV opportunities, especially if the stock market has been conditioned to believe that high dividends signal a high-quality firm. Our model thus emphasized managerial communication/education of investors, supported by managerial reputation considerations, as a means of eliminating this problem. We now consider some anecdotal evidence that provides a practical perspective to our theory, and demonstrates the real-world confusion surrounding dividend policy. 4.1 The traditional positive relationship between dividends and firm value Lease et al. (2000) provide the following examples where the market reacted in the standard way, that is, positively (negatively) to dividend increases (decreases):
Figgie International announced a cut in its quarterly dividend. [. . .] on the announcement Figgies stock price declined. [. . .] Bethlehem Steel Corporation announced that it was omitting its quarterly dividend. [. . .] Its share price fell.[. . .] Wal-Mart Stores announced an increase in its quarterly dividend. [. . .] Wal-Marts share price increased. [. . .] Procter and Gamble Company announced an annual dividend increase [. . .] on the announcement, P and Gs share price increased.

However, Lease et al. (2000) demonstrate that management understands that high dividends may restrict corporate investment in value-creation:

Elisabeth Goth, a dissident member of the family that controls Dow Jones and Co., raises questions about its dividend policy, contending that Dow Jones has increased its dividends at the expense of re-investing its earnings to fuel future growth.

However, shareholders who enjoyed stock run-ups and rising dividends in the 1980s are unhappy that Bell CEOs want to curb dividend growth and use profits to improve their networks and diversify at home and abroad. This suggests that investors may understand that dividends may need to be cut to invest in company growth, but they still demand dividends. 4.2 Dividend cuts are not always bad news! Our analysis revealed that dividend cuts are not always bad news, especially when a firm has significant growth opportunities available. However, we demonstrated that managers may refuse to cut dividends for fear of negative market reaction (which may be driven by investors being behaviourally conditioned to believe that dividend cuts are bad news). Our model suggested that the problem may be mitigated if managers can communicate the reasons for dividend cuts (to invest in new value-adding projects), supported by managerial reputation effects. Indeed, Cohen and Yagils (2006) international survey of CFOs of major companies in USA, UK, Germany, Canada and Japan reveals that this agency problem exists. The authors argue that managers should consider two factors when deciding whether to cut dividends: (1) How sensitive is the stock price to dividend changes (the adverse selection problem)? (2) To what extent can managers transfer information (that is communicate) about the profitable investment opportunity so that investors will understand the reason for the dividend increase? Indeed, they state:
If the managers believe that the reason for the dividend cut can be effectively communicated to investors in such a manner that it would not result in a dramatic stock price decrease, then they should prefer investing over paying the full amount of the dividend. On the other hand, if they believe that a drastic decline in the stock price may occur, then they should continue with the normal dividend plan and postpone the investment opportunity. The flow of information factor should be derived from the structural investors relations networks and from past experience.

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Lease et al. consider two examples of firms changing their dividend policy; WindermereDurable Holdings, Inc., and Compaq Computer Corporation. Windermere-Durable Holdings, Inc., announced that it was cutting the dividend in order to re-invest all earnings into the business, following a re-evaluation of its dividend policy in light of the Companys strategic repositioning for growth and the resulting cash requirement. On the release of the dividend-cut announcement, the firms share price increased from $18.25 to $19.00 (hence, the dividend cut, supported by positive communication to the market, was seen as good news). In contrast, Compaq Computer Corporation paid a dividend for the first time in 1997, causing its share price to fall (a dividend initiation was seen as a bad news signal that the company had run out of good investment opportunities). Wooldridge and Ghosh (1998) emphasize the importance of corporate communication and managerial reputation when cutting dividends to invest in growth. They compare the cases of Gould Inc. and ITT. In 1983, Gould Inc. announced that it

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was cutting its quarterly dividend in order to conserve cash that can be used to finance the growth of its electronic businesses [. . .] the board set the new dividend in the light of the companys transition to a high-technology firm. On the day of the announcement, its share price increased. In contrast, ITT announced a 64 per cent cut in its dividend payment, explaining that its dividend level had become inconsistent with the intensely competitive hightechnology environment. ITTs share price fell[21]. 5. Conclusion We have developed a dividend-signalling model that begins to address Fisher Blacks (1976) dividend puzzle. We demonstrated that the relationship between managerial incentives, dividend policy and firm value is indeed complex. In our model, dividends served a dual purpose. They signalled current income, and they affected the firms ability to invest in new projects. We therefore argued that dividends may provide confusing signals to investors, who may view an increase in dividends favourably, either as a positive signal of current income (that is dividends reduce asymmetric information problems), or as a means of mitigating free-cash-flow problems (that is dividends reduce agency problems). However, a dividend increase may be seen as a negative signal (the firm lacks growth opportunities), while a dividend cut may be seen as a positive signal (the firm has significant growth opportunities available). Our model identified two potential agency problems associated with dividend policy. First, the manager may cut dividends in order to invest in a negative NPV project, due to private benefits. Second, the manager may be unwilling to reduce dividends to take a positive NPV project, since he is concerned with the negative signal of current income. We suggested that the latter problem may be mitigated by communication to investors, reinforced by managerial reputation effects. We believe that our integrated model has provided a springboard for future theoretical and empirical research into the complex nature of corporate dividend policy.
Notes 1. See, for example, Bhattacharya (1979), Miller and Rock (1985), John and Williams (1985) and Ambarish et al. (1987). 2. We note that Fuller and Blau (2010) also developed a formal and rigorous integrated model, independently of ours (we became aware of their paper as we were completing ours). However, our model has several differences compared with theirs, as outlined below. 3. Our model is integrated in the sense that it combines both the signalling and free cashflow effects of dividend policy. However, for the sake of clarity and tractability, we consider these two agency problems as separate cases within the framework of our model. 4. This adverse selection problem is similar to that analysed by Myers and Majluf (1984). In their analysis, the adverse selection problem relates to a manager of a good firm refusing to issue undervalued equity, hence passing up a good investment opportunity. 5. We do not model this behavioural factor in any deep way. Models that consider psychological underpinnings are Baker and Wurgler 2004 (dividend catering), and Shefrin and Statman 1984 (self-control). 6. Note that we discuss the refusal to cut dividends in more depth, and consider real-world examples, in section 3. 7. It is common in theoretical analysis of corporate finance policy to focus on one decision, holding other decisions constant. In this paper, we wish to focus on the dividend decision, without the complication of capital structure. Hence, we make the standard assumption

8. 9. 10. 11.

12.

13.

14.

15. 16.

that firms are all equity. It is worth noting that some scholars have considered the dividend and debt/equity decision jointly. For instance, Jensen (1986) considers the role of dividends and debt as substitutes for each other in controlling managerial free cash-flow problems (whereas we focus on dividends). Furthermore, Easterbrook (1984) discusses a firms simultaneous decision to finance increased dividends by re-visiting the capital market, hence reducing agency problems by subjecting itself to market scrutiny. Finally, Agrawal and Mandelker (1987), Agrawal and Nagarajan (1990) and Agrawal and Jayaraman (1994) empirically examine all-equity US firms, and suggest that these firms have higher dividends than those with debt. They argue that this supports Jensens (1986) argument that these firms are substituting dividends for debt. In this paper, if we allow firms to re-visit the capital market, then our dividend signalling model would break down, as the bad firm could pay more dividends than income, simply by borrowing or issuing equity. Furthermore, our firms could alleviate the free cash-flow problem by issuing debt rather than paying dividends. In order to keep the analysis clean, and to focus on dividend policy, we implicitly assume that visits to the capital market are prohibitively costly (see[10]), so that: (i) firms prefer an all-equity structure to one including debt, and (ii) firms must use internally generated cash to pay dividends and/or invest in future projects. Note that this essentially is the approach adopted by Miller and Rock (1985). Hence, agents are only concerned with expected cash flows (and not the associated variance), and the market discounts future cash flows at a zero discount rate. Throughout the analysis, we refer to the firm run by the good manager as high quality and the firm run by the bad manager as low quality. It is assumed that the manager is unable to return to the capital market to raise the required funds for the new project. A commonly analysed agency problem is that of managers receiving private benefits from running a project, in addition to, and independently of, the monetary benefits, such as equity stakes. Indeed, Jensen (1986) discusses how managers might waste free cash flows on large, empire-building, projects, due to the private benefits that they obtain, even though these projects may be value reducing. Recall that manager B is unable to invest in the new project. He therefore has the choice of investing his cash flow Nb in the financial markets or as a dividend. We assume that he pays it all as dividend. When solving a Bayesian dividend-signalling game, the steps are as follows: we need to specify how the market updates its beliefs upon observing the firms simultaneous dividend choices; given these beliefs, we need to work out how the managers choice of dividends will affect their payoffs; we need to consider each managers best response to the others strategies; and we need to demonstrate that, in equilibrium, the managers behaviour is consistent with the beliefs (see Appendix A.2 for a worked example). Note that these beliefs are not assumptions, but are carefully considered and thought through by the modeller. Indeed, Rasmusen argues that the skill of the modeller of a signalling game lies in specifying beliefs that are consistent with the equilibrium of the game. In this case, we will demonstrate that investors are correct in this belief. In case 2 below, we consider how investors, conditioned to believe that high dividends signal high quality, lead to an adverse selection model, where the high-quality firm refuses to cut dividends to take the positive NPV project. We then consider the effects of communication and reputation. Please see the appendix for all of the payoffs for the various dividend combinations. Note that if we do not make this assumption regarding the reputation parameter, the game becomes much more complex. We leave analysis of this for future research.

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17. We are grateful to an anonymous referee for suggesting this interesting extension to the model. 18. This is in contrast to the normal procedure for solving games, which involves backward induction from the very end of the game (we would have had to employ this method if the firms and the investors had perfect foresight from the beginning of the game to the end of stage 2). 19. There is considerable evidence that dividends are sticky; that is, once firms have increased dividends, they find it difficult to cut them again, even when they need to do so to invest in new projects. Lintner (1956) was the first to identify this feature, which he termed dividend smoothing. 20. In our models, there is never an incentive for firms to pay high dividends that lead to a reduction in value. An equilibrium does exist where firms refuse to cut dividends to take a value-adding project. Therefore, high dividends are not actually value reducing in our model, but they mean that firms are foregoing value creation, since they are passing up positive NPV projects. In reality, there are cases of firms increasing dividends, and seeing firm value fall: e.g. Microsoft paid a dividend for the first time in 2003, and its share price fell dramatically. I think Microsoft is sending a message to shareholders that the story has changed from one of a high-growth company to a mature company [. . .] The day Microsoft declares a cash dividend is the day people no longer think of it as a growth stock. (web source: Microsofts Dividend Signals a New Era for Company. Helen Jung, 20 January 2003). 21. For an interesting discussion on dividend policy, and the trade-off between paying dividends and investing for growth, see A Discussion of Corporate Dividend Policy in Six Roundtable Discussions of Corporate Finance, edited by Joel Stern. In this chapter, academics and practitioners discuss whether firms should pay a high level of dividends when they have significant growth opportunities. The general academic view is that dividends should be cut. Interestingly, the practitioner view is that the firm should cater to investors with high dividends, thereby eschewing profitable investments. Stern argues for cutting the dividend, and emphasizes the role of communication and reputation. 22. Recall that if manager G can invest in the new project, he will. 23. Note that, if Assumption 1 was violated, then (A.1) would exceed (A.2). Now, the new project would have such a large negative NPV that, if manager G was choosing between Dg Nb and Dg Ng I, he would prefer to choose Dg Nb to mimic the bad manager (in order to reduce the markets assessment that he will be able to take the new project). In order to avoid this strange outcome, we maintain Assumption 1. 24. In game theory, a normal form game is a table that represents the interaction of simultaneous strategic decisions by two players, and the payoffs associated with those choices. In the Appendix table, the left-hand column represents the dividend choices of firm G. The top row represents the dividend choices of firm B, and the cell numbers represent the subsequent payoff equations from the combination of the two firms choices. The firms make their choices simultaneously. Therefore, each player cannot observe the other players decision when making its own choice, and so must attempt to second-guess what the other player will do. We solve such games by considering each players best response to each of the other players choices (for example, firm B asks itself, If I expect firm G to choose Dg Ng I, what is it optimal for me to do. Each firm makes such calculation for each of the other firms choices. This leads to an iterative process of expectations and counter-expectations (if I expect my opponent to do X, it is best for me to do Y. If he is expecting me to respond to X by doing Y, he will do Z, so I will respond to Z by doing. . .). In a Nash equilibrium, both players are optimizing, given this iterative process, and there is no incentive for either player to unilaterally deviate from the equilibrium strategies, since that player will then be worse off.

25. A player has a dominant strategy if it is his optimal strategy, regardless of his opponents choice of strategy. References Agrawal, A. and Jayaraman, N. (1994), The dividend policies of all-equity firms: a direct test of the free cash flow theory, Managerial and Decision Economics, Vol. 15, pp. 139-48. Agrawal, A. and Mandelker, G. (1987), Managerial incentives and corporate investment and financing decisions, Journal of Finance, Vol. 42 No. 4, pp. 823-37. Agrawal, A. and Nagarajan, N.J. (1990), Corporate capital structure, agency costs and ownership control: the case of all-equity firms, Journal of Finance, Vol. 45, pp. 1325-32. Allen, F. and Michaely, R. (2002), Payout policy, CFI Working Paper No. 01-21, Wharton School Center for Financial Institutions, University of Pennsylvania, Philadelphia, PA. Ambarish, R., John, K. and Williams, J. (1987), Efficient signalling with dividends and investments, The Journal of Finance, Vol. 42, pp. 321-44. Baker, M. and Wurgler, J. (2004), A catering theory of dividends, The Journal of Finance, Vol. 59 No. 3, pp. 1125-65. Bhattacharya, S. (1979), Imperfect information, dividend policy, and the bird in the hand fallacy, Bell Journal of Economics, Vol. 10, pp. 259-70. Black, F. (1976), The dividend puzzle, Journal of Portfolio Management, Vol. 2, pp. 5-8. Brucato, P. and Smith, D. (1997), An analysis of the role of firm reputation in the markets reaction to corporate dividends, The Quarterly Review of Economics and Finance, Vol. 37 No 3, pp. 647-65. Cohen, G. and Yagil, J. (2006), A multinational study of agency costs of dividends, International Journal of Finance and Economics, Vol. 6, pp. 178-83. Easterbrook, F. (1984), Two agency-cost explanations of dividends, American Economic Review, Vol. 74 No. 4, pp. 650-9. Fluck, Z. (1995), The optimality of debt versus outside equity, mimeo, NYU, New York, NY. Frankfurter, G. and Wood, B. (2002), Dividend policy theories and their empirical tests, International Review of Financial Analysis, Vol. 11, pp. 111-38. Fuller, K. and Blau, B.M. (2010), Signaling, free cash flow, and nonmonotonic dividends, The Financial Review, Vol. 45, pp. 21-56. Fuller, K. and Thakor, A. (2002), Signaling, free cash flow, and nonmonotonic dividends, SSRN working paper, available at: http://ssrn.com/abstract343980 Gillet, R., Lapointe, M. and Raimbourg, P. (2008), Dividend policy and reputation, Journal of Business, Finance and Accounting, Vol. 35 Nos 3/4, pp. 516-40. Jensen, M. (1986), Agency costs of free cash flow, corporate finance and takeovers, American Economic Review, Vol. 76, pp. 323-39. John, K. and Williams, J. (1985), Dividends, dilution, and taxes: a signaling equilibrium, Journal of Finance, Vol. 40, pp. 1053-70. Lease, R., John, K., Kalay, A., Loewenstein, U. and Sarig, O. (2000), Dividend Policy, Its Impact on Firm Value, Harvard Business School Press, Boston, MA. Lintner, J. (1956), Distribution of Incomes of Corporations among dividends, retained earnings and taxes, American Economic Review, pp. 97-113. Miller, M. and Modigliani, F. (1961), Dividend policy, growth, and the valuation of shares, Journal of Business, Vol. 34, pp. 411-33. Miller, M. and Rock, K. (1985), Dividend policy under asymmetric information, The Journal of Finance, Vol. 40, pp. 1031-51.

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Myers, S. and Majluf, N.S. (1984), Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, Vol. 13 No. 2, pp. 187-221. Shefrin, H. and Statman, M. (1984), Explaining investor preference for cash dividends, Journal of Financial Economics, Vol. 13, pp. 253-82. Wooldridge, J.R. and Ghosh, C. (1998), Dividend cuts: do they always signal bad news?, in Chew, D.H. and Stern, J.M. (Eds), The Revolution in Corporate Finance, 3rd ed., Blackwell Publishers, Malden, MA, pp. 143-50. Further reading Chew, D.H. Jr (Ed.) (1986), Six Roundtable Discussions of Corporate Finance with Joel Stern, Quorum Books, New York, NY. Appendix Proof of P1 Manager B must choose Db Nb. Manager G chooses a dividend from Dg 2 Nb, Ng I, Ng. Manager G and manager B choose their dividend levels simultaneously. Consider manager Gs best response to Db Nb, given the markets posterior beliefs (upon observing the two managers dividend choices). If manager G pools with manager B by choosing Dg Nb (such that manager G is able to invest in the new project[22]), the market is unable to update its beliefs (continuing to assign equal probability to each manager being of each type, G or B). Therefore, the date 1 market value of each firm is determined by the market beliefs that there is an equal probability of each firm having current cash flow of Ng or Nb, and a probability of 0.5 of each firm being able to invest in the new project. Since manager G has chosen, therefore manager Gs date 1 payoff is   Y Ng Nb I b A:1  V b  1 G 2 If manager G separates from manager B by choosing Dg Ng I, the market updates its beliefs to (correctly) assess him as manager G. Furthermore, the manager is able to invest in the new project (which the market incorporates into its date 1 valuation). Therefore, manager Gs payoff is Y Ng I b A:2 G If the manager separates from manager B by choosing Dg Ng, again, the market updates its beliefs to (correctly) assess him as manager G. In contrast to above, the manager is now unable to invest in the new project (and the market is aware of this). Therefore, manager Gs payoff is now Y Ng A:3 G

Assumption 1. I > Nb Ng, ensures that (A.2) > (A.1). This assumption sets a lower limit for the possible negative value of the new project, and ensures that, if manager G is choosing between Dg Nb and Dg Ng I, he will prefer to choose Dg Ng I to separate from the bad manager (so that the market will be aware that his firm has high current income and will be able to invest in the new project)[23].
Since (A.2) > (A.1), we only need to compare (A.2) and (A.3). Manager G prefers to choose Dg Ng I (in order to separate from manager B and be able to take the new project) if (A.2) > (A.3) > I b > 0. He prefers to choose Dg Ng (in order to separate from

manager B, and commit to the market not to take the new project) if (A.3) > (A.2) > I b < 0. This proves P1. Proof of P2 We solve the following normal form[24] game (the first number in each cell represents manager Gs payoff, and the second number in each cell represents manager Bs payoff. represents manager Gs best responses, represents manager Bs best responses. In this table, we have only demonstrated the definite best responses (see[24]), which are invariant to the parameters of the model).
G\ B Dg Ng I Dg Nb Dg Ng Db NgI 1, 2 5, 6 9, 10 Db Nb 3, 4 7, 8 11, 12

Dividend policy, signalling and free cash flow 411

We assume the following regarding the markets posterior beliefs (that is, the markets updated beliefs, having observed the two firms dividend decisions). If the market observes that both managers choose the same dividend, the market is unable to update its beliefs (and, therefore, continues to assign equal probability to each manager being of each type). If the market observes different dividend choices, the market believes that the manager G pays the higher dividend. Given these beliefs, the market valuation of the two firms is updated. Given that each manager receives a fraction  2 [0, 1] of the updated market value, the payoffs are as follows (where (T1) refers to table payoff 1):   Y Ng Nb I T1  G 2 Y
B

  Ng Nb I  2 Y
G

T2

Nb NG NG NB

T3

Y
B

T4

Y
G

T5

Y
B

T6

Y
G

  Ng Nb  2   Ng Nb  2

T7

Y
B

T8

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G

NG

T9; T11

Y
B

NB

T10; T12

412

First, we prove P2a, where NG NB < I. Consider manager Bs best (optimal) responses to each of manager Gs decisions (see[22] for an explanation of this process). If manager G chooses Dg Ng I, manager B chooses Db Ng I for sure, since NG NB < I > (T2) > (T4). If manager G chooses Dg Nb, manager B chooses Db Nb for sure, since (T8) > (T6). If manager G chooses Dg Ng, manager B is indifferent between choosing Db Ng I and Db Nb, since (T10) (T12). We assume that, in the case of indifference, the manager chooses Db Nb. Next, consider manager Gs best responses to each of manager Bs choices. If manager B chooses Db Ng I, manager G chooses Dg Ng I, for sure, since (T1) > (T5) (T9) when NG NB < I. If manager B chooses Db Nb, manager G chooses Dg Ng for sure, since (T11) > (T7) > (T3). In order to obtain the Nash equilibrium of the game (see[24] for an explanation), we combine the two managers best responses. The equilibrium strategies occur where each managers best response appears in the same box of the table (that is, where the and appear together). Thus, we obtain the multiple equilibria Dg* Ng I, Db* Ng I and Dg* Ng, Db* Nb. This proves P2a). Second, we prove P2b, where NG NB > I. Consider manager Bs best responses to each of manager Gs decisions. If manager G chooses Dg Ng I, manager B chooses Db Nb for sure, since NG NB > I > (T4) > (T2). If manager G chooses Dg Nb, manager B chooses Db Nb for sure, since (T8) > (T6). If manager G chooses Dg Ng, manager B is indifferent between choosing Db Ng I and Db Nb, since (T10) (T12). We assume that, in the case of indifference, the manager chooses Db Nb. Therefore, in the case NG NB > I, manager Bs dominant strategy[25] is to choose Db Nb. Given manager Bs dominant strategy, Db Nb, manager Gs best response is to choose Dg Ng for sure, since (T11) > (T7) > (T3). Therefore the equilibrium is Db* Nb, Dg* Ng. This proves P2b. Proof of P3 We focus on the case where NG NB > I (the adverse selection effect dominates the new projects positive NPV). In the absence of reputation considerations, the equilibrium is Db* Nb, Dg* Ng; that is, the good manager refuses to cut the dividend, thereby passing up the positive NPV project. We now incorporate the following two steps. Firstly, at the time of the dividend announcement, the managers communicate to, and educate, the market to change market beliefs, such that, if the market observes Di Ng I, with Dj Nb, the market believes that the highquality firm, firm G, is choosing the lower dividend Di Ng I (in order to invest in the new project). If the market observes Dg Db Ng I, it cannot update its beliefs, but knows that one firm is able to invest in the new project. Since manager B can mimic manager Gs dividend Di Ng I, our second step is to consider a reputation stage as follows. If manager B chooses Db Ng I, with manager G either choosing DG Ng I, or DG Nb, then, when type is revealed at date 2, manager B suffers a reputation cost r for lying. Steps (1) and (2) together affect payoffs (T2)-(T6) as follows (all of the other payoffs remain as in the proof for P2):

Y
B

  N g N b I r  2 Y
G

T20

Dividend policy, signalling and free cash flow 413

Ng I

T30 T40 T50 T60

Y
B

Nb Nb

Y
G

Y
B

Ng I r

Under the assumption that r > Ng Nb =2 I , it can be demonstrated that manager Bs dominant strategy is to choose Db Nb. (In particular, the reputation effect is strong enough to prevent him from mimicking manager G.) Given this dominant strategy, manager Gs best response is to choose DG Ng I. Therefore, the equilibrium is DG* Ng I. Db* Nb. This proves P3. Corresponding author Richard Fairchild can be contacted at: mnsrf@bath.ac.uk

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