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. We 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. We find that higher cash flow firms suffer more severe agency problems. Moreover we find that takeover threats reduce these problems in high cash flow firms but not low cash firms. Finally, we find evidence that takeover threats cause managers in low cash flow firms to make myopic withdraws in order to signal generosity. ∗I am grateful to Vernon Smith, David Porter, Bart Wilson and two helpful referees for the comment. I am also grateful to the International Foundation for Research in Experimental Economics and the Interdisciplinary Center for Economic Science for their generous support. Any mistakes are my own. †Economics Department, University of California, Santa Cruz, CA, 95064. [email protected]