Richard J. Fairchild

Dividend policy, signalling and free cash flow: an integrated approach

Purpose - Scholars have examined the importance of a firms dividend policy through two competing paradigms: the signalling hypothesis and the free cash-flow hypothesis. It has been argued that our understanding of dividend policy is hindered by the lack of a model that integrates the two hypotheses. The purpose of this paper is to address this by developing a theoretical dividend model that combines the signalling and free cash-flow motives. The objective of the analysis is to shed light on the complex relationship between dividend policy, managerial incentives and firm value. Design/methodology/approach - In order to consider the complex nature of dividend policy, a dividend signalling game is developed, in which managers possess more information than investors about the quality of the firm (asymmetric information), and may invest in value-reducing projects (moral hazard). Hence, the model combines signalling and free cash-flow motives for dividends. Furthermore, managerial communication and reputation effects are incorporated into the model. Findings - Of particular interest is the case where a firm may need to cut dividends in order to invest in a new value-creating project, but where the firm will be punished by the market, since investors are behaviourally conditioned to believe that dividend cuts are bad news. This may result in firms refusing to cut dividends, hence passing up good projects. This paper demonstrates that managerial communication to investors about the reasons for the dividend cut, supported by managerial reputation effects, may mitigate this problem. Real world examples are provided to illustrate the complexity of dividend policy. Originality/value - This work has been inspired by, and develops that of Fuller and Thakor, and Fuller and Blau, which considers the signalling and free cash-flow motives for dividends. Whereas those authors consider the case where firms only have new negative net present value (NPV) projects available (so that dividend increases provide unambiguously positive signals to the market in both the signalling and free cash-flow cases), in this papers model, the signals may be ambiguous, since firms may need to cut dividends to take positive NPV projects. Hence, the model assists in understanding the complexity of dividend policy.

Dividend smoothing and optimal re‐investment

Lintner’s (1956) survey revealed that managers are concerned about dividend signalling over time, and adopt a smoothing policy. In addition to signalling, dividend policy may affect a firm’s re‐investment opportunities, particularly if it is capital constrained. In this paper, we examine the interaction between dividend smoothing/signalling and optimal re‐investment. We develop a dividend policy model that considers both an optimal level of dividends (and re‐investment) at each point in time, and optimal smoothing over time. Our model provides both theoretical insights, and provides a practical management tool for dividend policy.

A Theory of Entrepreneurial Overconfidence, Effort, and Firm Outcomes

We present a theory of entrepreneurial behavior that explores the relationship between overconfidence and successful firm outcomes, such as acquisition or IPO. In our model, increasing overconfidence produces two conflicting effects on the probability of a successful outcome: it not only induces an entrepreneur to increase the riskiness of a venture (which lowers the likelihood of successful exit), but also drives higher entrepreneurial effort, increasing likelihood of a successful exit. Due to this conflict, a kinked or U-shaped relationship may exist between overconfidence and positive outcomes. Furthermore, our model suggests that increased outside equity mitigates the effects of overconfidence.

Does Audit Tenure Lead to More Fraud? A Game-Theoretic Approach

We consider the effect of auditor tenure on the level of managerial fraud and the extent of auditor qualification of reports. We consider two conflicting effects. As auditor tenure increases, the auditors ability to detect fraud increases, which reduces the managers fraud incentives. On the other hand, the auditor may become more sympathetic towards management, which may increase fraud incentives. In order to analyse these issues, we develop an auditing game in which the manager makes an unobservable decision whether or not to commit fraud. The auditor then decides whether to perform a basic or extended audit. The level of audit affects the probability of fraud-detection. Following the outcome of the audit, the auditor then decides whether to issue a qualified or unqualified report. We consider the ethical dimensions of our model, and we provide policy implications in relation to the debate regarding mandatory turnover of auditors.

Financial risk management: is it a value‐adding activity?

Considers whether financial risk management is value‐adding. Although risk management can reduce total risk, this may not affect the cost of capital or firm value. Well‐diversified investors have already eliminated all of the specific risk, and risk‐management may be seen as a zero NPV activity at best, and at worst, a value‐reducing activity. However, there is a role for risk management. Reduction of total risk may reduce the expected costs of financial distress, hence increasing expected cashflows. This increases firm value. Presents a method of investment appraisal that takes account of total risk through expected financial distress costs. Such a method can result in three possible decisions relating to a new project; reject the project invest in the project; and risk‐manage; or invest in the project but do not risk‐manage. Finally, presents worked examples.

The Effects of Self-Interest and Fairness on Entrepreneur/Venture Capitalist Financial Contracting and Performance

I consider the effects of entrepreneurial inequity-aversion on financial contracting with a self-interested venture capitalist, in a single-sided and double-sided moral hazard setting. In the pure principal-agent model, as the proportion of self-interested entrepreneurs in the population increases, the venture capitalists optimal equity offer to the entrepreneur decreases, and the entrepreneur reduces effort. Welfare is maximized when there is a mix of self-interested and inequity averse entrepreneurs in the population. In the double-sided moral hazard setting, the first-best level of welfare is achieved when an inequity-averse entrepreneur matches with a self-interested value-adding venture capitalist, and the threat from ex post opportunism is low.

The Effects of Fairness and Moral Hazard in Bargaining

We consider the impact of fairness and moral hazard in a principal-agent bargaining model, where the agent can affect the size of the surplus by his actions. Our main results are as follows; a) the offer predicted by the basic fairness model (excluding moral hazard) results in inefficient behaviour by the agent when moral hazard is introduced; b) a moral hazard-eliminating offer exists; c) this offer exceeds the offer predicted by the basic fairness model; d) however, fairness considerations may eliminate the principals incentives to make this offer.

Financial Bargaining Between Managers and Venture Capitalists

We analyse bargaining between a venture capitalist and a manager over their financial contract. We consider three main questions. What is the effect of bargaining, and when will it provide the first-best solution? What is the effect of bidding between competitive venture capitalists to supply finance? What is the impact of convertible debt on the bargaining process? Our paper should be of interest to managers of start-up firms, venture capitalists, and policy makers. It provides an insight into the conflicts involved in the financial negotiation process, and it provides policy implications.

The Conflict Between Economic and Social Preferences: Social Investing, Social Enterprise, Mind-Sets and Nudges

Investing into the financial markets has become increasingly complex in recent years, with a multitude of investment products and motives. With the rapid growth in social investing and social entrepreneurship, scholars recognise that investors and entrepreneurs often consider a wide range of social factors, in addition to financial return, when making their financial decisions. Behavioural economists argue that it is important to understand the complex economic and behavioural/psychological factors affecting social investors’ decision-making. In this paper, we draw upon lessons from behavioural economics (and in particular, social preference theory) in order to develop neuro-economic tests of investors’ social and financial mind-sets. We focus on two main research questions: a) How heterogeneous are (social-) investors, in terms of the unconscious weightings that they place upon financial and social returns? Can investors’ mind-sets be placed upon a continuum from focussing on social returns, through mixed motivations/weightings, through to focussing on financial returns? b). Can investors be nudged along this continuum? We address these two research questions by means of two neuro-experiments. We employ eye-tracking techniques to examine investors’ attention to, and fixation on, social and financial aspects of financial market investment. In addition, we employ nudges in the form of images relating to positive and negative social behaviour. Our experiments demonstrate that a) investors can indeed be placed on the financial-social motivation continuum (and that there is heterogeneity in social-investors’ motives along this scale), and b) investors can be nudged along the scale. Our experiments thus provide policy implications regarding nudges towards social investment. Practically, we suggest the development of a phone application that integrates real-time stock-tracking with nudges in order to inspire socially responsible investing; banks would play a key role in encouraging its download. Nudges can help to overcome the conflict between social and financial returns.

An Entrepreneur's Choice of Crowd-Funding or Venture Capital Financing: The Effect of Entrepreneurial Overconfidence and CF-Investors’ Passion

We develop a game-theoretic analysis of an entrepreneur’s choice between venture capital financing or crowdfunding in order to finance his new innovative start-up. If he chooses venture capital, the venture capitalist provides value-creating effort (in addition to the E’s own effort). However, the E must share some of the equity with the VC. If the E chooses crowd-funding, then the E keeps all of the equity in excess of that required to induce CF-investment. However, the CF-investors are passive, and do not provide any value-creating efforts. Furthermore, we consider ‘network benefits’ provided by VC-finance, and CF-investors’ behavioural/emotional excitement when investing through the platform. The E trades-off all of these factors in making his financing-choice. A major contribution of our analysis is that we consider the effects of entrepreneurial overconfidence (in the CF-funders’ emotional excitement versus the network benefits of VC-finance) on his choice. We conclude with a survey of real-world CF-investors.