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Licensed Unlicensed Requires Authentication Published by De Gruyter September 15, 2007

Free Cash Flow and Managerial Entrenchment: A Continuous-Time Stochastic Control-Theoretic Model

  • Abel Cadenillas and Steven P Clark

In this paper, we formulate a model prescribing optimal policy for cash disbursements and seasoned equity offerings taking into account the principal-agent problems inherent in these decisions. In order to discipline managers, stockholders demand that excess free cash flow be disbursed either as cash dividends or through stock repurchases. Managers resist stockholders in this regard since they prefer to retain excess free cash flow in order to pursue personal interests and reduce the probability that the company will experience financial distress in the future. However, as a consequence of withholding cash disbursements, managers incur disutility due to the possibility that their control of the firm could be threatened by the market for corporate control. We model this situation as a stochastic impulse control problem, and succeed in finding an analytical solution. We derive several testable implications, some of which have not been fully addressed in the corporate finance literature.

Published Online: 2007-9-15

©2011 Walter de Gruyter GmbH & Co. KG, Berlin/Boston

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