Free Cash Flow And Takeover Threats: An Experimental Study

A classic theory of corporate governance holds that, when cash flow is high and investment opportunities scarce, takeover threats reduce managerial self dealing and encourage dividend payment to owners. The authors conduct laboratory experiments studying the effect of cash flow on self dealing and the effect of takeover threats on both agency problems and the optimality of management of cash flows. The authors find that higher cash flow firms suffer more severe agency problems. Moreover the authors find that takeover threats reduce these problems in high cash flow firms but not low cash firms. Finally, the authors find evidence that takeover threats cause managers in low cash flow firms to make myopic withdraws in order to signal generosity.