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The authors extend John and John's (1993) theoretical analysis of financial policy and managerial incentives to incorporate free cash flow, payout policy, and debt covenants, and test the theory empirically. To maintain efficient investment incentives, the manager's pay-performance sensitivity declines with the firm's dividend payout. A flexible payout policy, including intermittent share repurchases, is optimal when the firm faces stochastic cash flows. Since management does not participate in repurchase programs, repurchases increase their pay-sensitivity. The flexible payout policy creates an opportunity for managers to pay expropriating dividends that reduce bond values and distort investment choices.
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