Investment, Dividends, Firm Performance and Managerial Incentives : Another Insight into the Role of Corporate Governance

We combine the incentive schemes offered to managers in practice into a single incentive package and construct a governance index to analyze the role of governance and the incentive package in addressing the agency costs of free cash flow. Using US based data, we find empirical evidence that managers in practice do not consume perks but make a tradeoff when they allocate the cash flows of the firm between investment and dividends. In general, managers in practice underinvest and overpay dividends; an increase in their incentive package would retract both investment and dividends toward the optimal levels; hence, firm performance would improve. We also find that governance is used as a control mechanism rather than as a substitute for the incentive package. Principals employ governance to slow down investment and increase dividends when there is a high informational asymmetry between the manager and the investors, and set these variables close to the optimal levels otherwise. Moreover, we find that firms in practice do not use dividends as a substitute for governance. Furthermore, we find monotone relations between investment, firm performance and dividends on the one hand, and governance and the incentive package on the other hand