The Source of the Conflict

In examining debt policy, we noted that one reason for taking on more debt was to induce managers to be more disciplined in their project choice. Implicit in this free cash flow argument is the assumption that cash accumulations, if left to the discretion of the managers of the firm, would be wasted on poor projects. If this is true, we can argue that forcing a firm to make a commitment to pay dividends provides an alternative to forcing managers to be disciplined in project choice and to reducing the cash that is available for discretionary uses.

If this is the reason stockholders want managers to commit to paying larger dividends, firms in which there is a clear separation between ownership and management,

18 Palepu, K and P. Healy, 1988, Earnings Information Conveyed by Dividend Initiations and Omissions, Journal of Financial Economics, v21, 149-175.

should pay larger dividends than should firms with substantial insider ownership and involvement in managerial decisions.

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