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. I 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. I find that higher cash flow firms suffer more severe agency problems. Moreover I find that takeover threats reduce these problems in high cash flow firms but not low cash Firms. Finally, I find evidence that takeover threats cause managers in low cash flow firms to make myopic withdraws to signal generosity.