Free Cash Flow and Takeover Threats: An Experimental Study∗
June 22, 2007
A classic theory of corporate governance holds that, when cash ﬂow is high and investment opportu-
nities 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. firstname.lastname@example.org
This paper reports an experiment examining the eﬀects of takeover threats and cash ﬂow on managerial
decision making. Our laboratory environment is motivated by Michael Jensen’s (1986) free cash ﬂow theory
of takeovers which holds that ﬁrms that generate cash ﬂow with no high return projects to spend it on will
suﬀer from agency problems. Rather than disgorge cash to investors, managers with high cash inﬂows will
spend the money on zero return vanity projects, empire building, frivolous spending or even outright self
payment – behavior which we will collectively refer to as self dealing. These agency problems, Jensen argues,
are reduced when institutional factors in capital markets allow investors to force reorganization by selling
their interests in the ﬁrm. As Jensen (1986) and Scharfstein (1988) have noted, because these takeovers
are frequently motivated by a desire to overthrow management, the very threat of takeover can motivate
managers to keep investors happy by paying out free cash as dividends instead of engaging in self dealing.
In this sense, takeover threats are potentially good for investors.
Other authors, such as Stein (1988), have emphasized takeover threats’ potential to cause myopia in
management. When returns are uncertain, managers may be motivated to make decisions which please
investors in the short run, ignoring long run returns in the process. Managers may convince investors to
reject takeover bids in the short run by focusing on generating returns for them in the short run, even if at
the expense of long term returns. In other words, takeover threats might make managers myopic which may
ultimately be bad for investors.
Our experiment was designed to study these two potential eﬀects of takeover threats. The experimental
design models the ﬁrm as a stochastically evolving ﬂow of cash, owned by a representative investor and
governed by a manager. In each period, the manager chooses how much of the ﬁrms cash to leave in the
ﬁrm, how much to pay out to the investor in dividends, and how much to deal to himself. The ﬁrm is at its
eﬃcient scale, lacking growth prospects but still generating cash ﬂow. The lack of growth prospects means
that neither manager nor investor can inﬂuence cash ﬂow. The existence of cash ﬂow gives managers scope
for dividend payouts and room for self dealing. In the design, if the ﬁrms cash ﬂow ever drops below zero,
the ﬁrm is automatically liquidated by creditors, the manager is deposed and the investor loses remaining
interest (i.e. the experiment ends). One of the treatment variables we vary in this study is whether the ﬁrm
faces a takeover threat. In No Takeover treatments, the investor has no eﬀect on the payouts of the manager
and is therefore completely dependent on the managers goodwill for earnings. In Takeover treatments, the
investor can choose at any point to sell the ﬁrm to the experimenter at a ﬁxed price, thereby deposing of the
manager and ending the experiment. Our second treatment variable is cash ﬂow. In High Cash experiments,
the average amount of cash generated by the ﬁrm is higher than in Low Cash experiments.
This model of the ﬁrm closely mirrors the one described in free cash ﬂow theory. The ﬁrm generates
positive cash ﬂow, but there are no productive uses for it within the ﬁrm. Without viable investment
projects, this positive cash ﬂow can either be spent to beneﬁt the manager (for instance on unproﬁtable
empire building, vanity projects or even outright theft) or it can be paid out as dividends. This tradeoﬀ
between two uses of free cash creates a conﬂict of interest between manager and investor and a potential for
The typical concerns (associated for example with Stein (1988)) regarding takeover inspired myopia, is
that takeover threats might cause managers to make ineﬃcient project choices. Managers may choose to
invest in short run, quick return or low risk projects instead of long term growth projects in order to return
dividends to managers and stave oﬀ corporate raiders. It is diﬃcult to study this sort of myopia in the type of
environment described by free cash ﬂow theory because in such environments, and so in our design, the ﬁrm
has no growth projects available. However a diﬀerent opportunity for myopia presents itself in our design.
In addition to having direct value to investors and managers, cash insures the ﬁrm against runs of bad luck
in earnings which can lead to liquidation. Optimality requires managers to make no cash withdraws until
cash exceeds a critical safe barrier level. This robs the manager of an opportunity to signal willingness to
return funds early in the life of the ﬁrm. Under an optimal withdraw policy, investors must bear substantial
risk with little assurance that their managers are willing to make cooperative distributions of cash. In order
to assuage this risk and deter investors from accepting takeover bids, managers may have incentives to make
withdraws below the optimal barrier in order to signal that they are of a cooperative type. There is therefore
some behavioral scope for myopic distribution policies as a consequence of the takeover threat.
We ﬁnd evidence broadly supporting the relevant conjectures made by free cash ﬂow theory. Free cash
signiﬁcantly worsens managerial misbehavior. Moreover, takeover threats are eﬀective at reducing these
agency problems but only in high cash ﬂow ﬁrms. Finally we ﬁnd evidence that takeover threats inspire
myopic withdraws, though only in low cash ﬂow ﬁrms. As we argue below, this is consistent with the sort
of myopic generosity signaling described above.
Early observations on the governance value of the takeover threat were provided by Manne (1965), though
the pioneering formal work on the mechanics of how takeovers can force managerial payout of dividends was
conducted by Grossman and Hart (1980). The theoretical work which most directly addresses the use of
takeover threats in solving agency problems between managers and stockholders is Scharfstein (1988). A
useful survey on the agency problems that exist between sources of ﬁnance and management is provided
by Shleifer and Vishney (1997). There is also a small experimental literature on takeovers. Kale and Noe
(1997) report an experiment in which a number of investors, each holding a single share of a company, must
simultaneously decide whether to accept an exogenous takeover bid which will only be accepted if a threshold
number of subjects choose to accept the bid. Cadsby and Maynes (1998) is similar to Kale and Noe (1997)
except that investors have multiple shares and the bid requires only that a threshold number of shares (rather
than a threshold number of players) be sold. Gilette and Noe (2006) the eﬀects of resolicitation options on
free riding in takeover bids. Hamaguchi et. al. (2003) also study the free rider problems that plague takeover
attempts, formally studying popular models of the problem. The types of free rider problems explored in
these papers are abstracted from in the design reported here. Croson et. al. (2006) study bargaining over
synergies from takeovers and mergers in an environment quite diﬀerent from the one studied here.
The remainder of this paper will be organized as follows. Section 2.1 presents the basic model of the
ﬁrm used in this experiment and section 2.2 describes the treatments and parameters used. Section 2.2
and 2.3 describe optimal withdraw behavior and a testable hypothesis regarding myopic withdraws in our
experiment respectively. Sections 2.4 and 2.5 describe our main experimental questions and our experimental
procedures. Section 3 reports the results of the experiment and we conclude the paper in section 4.
Model of the Firm
Consider a ﬁrm consisting of one manager paired with one investor. The main attribute of the ﬁrm in period
t is its free cash, ct which evolves over time according to three factors:
1. An independently and identically distributed shock ε ∼ N (µ, σ2) is added to the ﬁrms free cash every
2. In each period, the manager chooses a non-negative amount wt to withdraw from the ﬁrm’s free cash
We will call this the manager’s withdraw policy.
3. In each period, the manager chooses how to distribute the withdraw between herself and the investor.
In particular, the manager chooses a fraction st of the withdraw to pay out to herself and a fraction
dt to pay out to the investor where dt + st = 1. We will call st the manager’s self dealing policy and
dt the manager’s dividend policy.
Thus the ﬁrm’s free cash in period t is:
ct = ct−1 − wt−1 + εt
The manager has two sources of income. He is paid a wage, e, for each period the ﬁrm is in business and
he is paid his self dealing withdraws. The manager’s cumulative earnings in period t is therefore:
πM = πM + s
t + e
The investor is paid only what the manager pays to him in dividends. He has no direct inﬂuence over
the distribution of the ﬁrm’s cash and is, in this basic setup, completely at the mercy of the manager. His
payoﬀ in period t is
πI = πI
Table 1: Parameters by treatment.
c0 (Initial Cash)
µ (Shock Mean)
σ (Shock Variance)
e (Manager Wage)
δ (End Probability)
m (Takeover Bid)
The experiment ends if one of two events occur. First, the ﬁrm is liquidated if its cash ﬂow ever drops
below zero and the experiment ends. We will call risk associated with liquidation liquidation risk. Second,
in order to induce discount rate time preferences, the ﬁrm may end with probability δ at the end of each
period. We will call the risk associated with the random ending the random ending risk. If the ﬁrm ends in
period T for either reason, the earnings to manager and investor are πM and πI respectively.
A ﬁnal aspect of the environment is that there is an asymmetry of information between the manager and
the investor. During the experiment, the investor knows the distributional properties of the evolution of free
cash, but can see only the dividends he is paid each period and the amount of cash left in the ﬁrm. The
investor does not know how much cash the manager is actually taking for herself.
The simple ﬁrm modeled by the design is intended to ﬁt the basic description of a ﬁrm ripe for takeover
oﬀered by free cash ﬂow theory. Because the random process governing the ﬁrm’s cash ﬂow does not change
over time, the ﬁrm is at its eﬃcient scale and has no useful projects to invest cash in. At its eﬃcient scale, the
ﬁrm generates positive cash ﬂows which can either be disgorged to investors or used to beneﬁt the manager.
Finally, the manager can take self beneﬁting hidden action which generates a conﬂict of interest with the
Parameters and Treatments
Parameters used in this experiment are given in Table 1.
We study two treatment variables: Takeover vs. No Takeover and High Cash vs. Low Cash. In No
Takeover sessions, subjects participate in the experiment as just described. In Takeover sessions, investors
have the additional option, at any point during the session, of ending the experiment and receiving an
amount m, which is ﬁxed across sessions and treatments, in addition to whatever earnings she has made up
to that point. In essence, the experimenter is a corporate raider oﬀering a ﬂat amount to take over the ﬁrm.
1 If a takeover bid is accepted in period T , the manager earns πM and the investor earns πI + m.
The No Takeover treatment models a ﬁrm with severe agency problems where ”breakdowns of internal
control processes” are predicted by free cash ﬂow theory to inspire takeovers (Jensen (1986)). This treatment
gives us a benchmark measure of the severity of agency problem in ﬁrms with the governance problems that
might draw takeover bids in the ﬁrst place. The Takeover treatment adds a single governance tool (the
takeover bid), allowing us to examine the eﬀects this tool alone has on managerial behavior.
In Low Cash sessions, the mean of the shocks to cash ﬂow each period is set at 1 while in High Cash
sessions it is set at 6. Thus, over time and on average, High Cash ﬁrms generate much higher cash ﬂows
than Low Cash ﬁrms.
The investor’s earnings can be regarded as a consequence of two distinct decisions by the manager. First
the manager chooses a withdraw policy wt and second he determines what fraction of the withdraw dt to
hand over as dividends. Clearly a manager’s dividend policy has a bearing on the investor’s earnings. By
choosing to deal withdraws to herself, a manager directly reduces payments to the investor. However, given
a choice dt, the manager’s withdraw policy itself has a powerful eﬀect on the investor’s earnings. Because
the ﬁrm and its future earnings is liquidated if ct < 0 and ct can fall, there is an insurance value to keeping
some level of cash in the ﬁrm. Withdraw policies which leave too little cash for insurance are myopic in the
sense that they reduce the expected total withdraws relative to that associated with an optimal policy.
Optimal withdraw policies are well deﬁned in continuous time versions of our environment. If cash ﬂow
evolves as an additive diﬀusion process (or arithmetic Brownian motion) with drift µ and volatility σ it can
be shown that the manager has a stationary optimal withdraw policy. It can be shown that the withdraw
policy which maximizes discounted withdraws is a barrier policy (see (9)) with some barrier b∗ :
ct − b∗
ct > b∗
dt + st =
ct ≤ b∗
That is, the strategy that maximizes future discounted withdraws has the manager withdrawing nothing
whenever the ﬁrm’s cash is below some threshold b∗ and withdrawing any excess cash above b∗ whenever
there is greater than b∗ in cash in the ﬁrm.2
The intuition for this result is as sketched above. Cash has
a certain insurance value for the ﬁrm. Since the ﬁrm is liquidated if it’s cash reserves drop below zero and
future withdraw options are terminated, it is prudent for the ﬁrm’s manager to maintain cash inside the
ﬁrm. At some point (in fact at the barrier b) the marginal value of holding cash for insurance drops to zero,
1The decision to treat m as an exogenous variable rather than a decision by an actual subject was purely a noise reducing
measure. This is a feature of the design that should be endogenized in future research.
2For a proof that the policy which maximizes discounted withdraws is a barrier policy, see Theorem 3.1 in Dutta and Radner
Figure 1: Mean total withdraws at various choices of barrier cash reserves, b in Low Cash and High Cash environ-
ments. Each data point is based on 1000 simulated experiments.
and all further funds should be withdrawn.
In order to generate predictions that are valid in our discrete environment3, we run simulations comparing
average total withdraws under various choices of the barrier, b∗. Figure 1 presents simulation results for both
the High and Low cash ﬂow environments. In the High Cash treatment there is a clear optimal barrier at 5.
Smaller barrier choices lead to expected withdraw loss due to added liquidation risks. Larger barrier choices
are too conservative, trading withdraws for excessive insurance. In the Low Cash treatment the optimum is
at 17. The diﬀerence in optima here are driven by diﬀerences in the likelihood of negative shocks to cash
ﬂow. Intuitively, negative runs are more likely in the Low Cash treatment leading to an increased insurance
value to accumulated cash.
3 Finding b∗ in a continuous time environment involves ﬁnding where the slope of the value function (the function describing
expected future returns as a function of current cash) is equal to one (see Harrison (1985)).
Dutta and Radner (1996) show
that the barrier is deﬁned by:
ln( λ )2
λ + θ
where θ is the positive root of 1 σ2x2 + µx − δ and λ is the absolute value of its negative root.
Why Might Takeovers Induce Myopic Withdraws?
Stein (1988) argues that, under asymmetric information, takeover bids can provide managers with incentives
to make decisions which sacriﬁce long term returns for short term ones. If managers know more about the
proﬁt potentials of the ﬁrm than investors, they can signal this potential by generating and distributing large
short term returns. This signaling can come at the expense of long term earnings but can have the eﬀect of
deterring investors from accepting takeover bids.
Although our environment is diﬀerent from the one modeled by Stein, it provides scope for a similar sort of
myopic signaling. Previous experimental evidence from bargaining games indicate heterogeneity in subjects’
willingness to distribute resources to counterparts. Many subjects are willing to disperse money to their
subject counterparts even with little ﬁnancial incentive to do so. This is particularly true in environments
in which, as is true here, counterparts have been framed by the experimenter as property right holders over
the pots being distributed (e.g. Hoﬀman et. al. (1994)). Other subjects act as traditional economic theory
predicts, distributing little to counterparts when incentives to do so are limited.
Such heterogeneity in generosity implies ex ante asymmetric information between the investor and man-
ager over the manager’s generosity and therefore managers’ willingness to make dividend distributions once
they begin making withdraws. This asymmetric information is damaging to investors because, in the Low
Cash treatment, cash ﬂows begin well below the barrier level. As a result, an investor must wait until cash
has evolved to the barrier level before discovering how generous her manager’s dividend policy will be and
therefore learning the relative value of the takeover bid. This waiting has a real cost to the investor because
she undertakes random ending risk while waiting for the barrier level of cash to accumulate. Depending on
his prior beliefs about the distribution of generosity in the manager population, the investor may be tempted
to accept the takeover bid instead of incurring these waiting costs.
Alternatively, an investor may turn away takeover bids if she receives dividends early in the experiment
as a signal of generosity. Such early withdraws would be myopic since they occur at cash reserves below the
barrier level and therefore serve to lower expected total withdraws. Early dividends are a pure cost to a
selﬁsh manager in that they lower the manager’s expected total withdraws and therefore her total payments
to self. Generous managers however may receive some non-pecuniary beneﬁts from early dividends, making
the provision of the signal less costly than it is to more selﬁsh types. It is therefore possible that myopic
withdraws might have a signaling function in our environment analogous to the one described in Stein (1988).
Rather than making myopic decisions to signal the proﬁtability of a ﬁrm as in Stein (1988), manager’s might
make myopic decisions to signal their private motivation to return dividends in later periods.
Myopic signaling policies of this sort generate clear testable predictions. In the High Cash treatment,
the optimal barrier of 5 is lower than the initial level of cash. Thus ﬁrms have an opportunity to signal their
generosity from the beginning of the experiment without departing from the optimal policy. Generosity
signaling therefore should not induce myopic withdraws in the High Cash treatment. In the Low Cash
treatment, however, the barrier of 17 is greater than the initial level of cash, meaning signaling generosity
early in the experiment requires the ﬁrm to use myopic policies. Thus under the myopic signaling hypotheses,
we should see increased myopic withdraws at cash levels below 17 in the Low Cash, Takeover treatment
(relative to Low Cash, No Takeover) but should see no change in withdraw patterns due to the Takeover
variable in High Cash treatments.
Our main experimental question is whether the disciplinary eﬀect of takeover threats is stronger than the
myopia-causing eﬀect. The core of the free cash ﬂow theory is the claim that conﬂicts of interest between
managers and investors are created by substantial levels of free cash ﬂow. This does not necessarily mean
that investors earn less on investments in higher cash ﬂow ﬁrms. Rather, it means that in such ﬁrms,
managerial self dealing increases relative to alternative uses of funds. Thus free cash ﬂow theory generates
a ﬁrst questions.
Question 1: Does higher cash ﬂow cause managers to deal a greater proportion of withdraws to themselves?
It is often argued that takeovers correct for these conﬂicts of interest between managers and shareholders.
In this design we are interested not in the eﬃciencies generated in the wake of a takeover (something not
modeled here) but in the eﬀect of the threat on managers. The threat of reorganization (which in this
experiment leads inevitably to turnover in management) gives managers an incentive to make investors happy
with dividend payouts. Takeover threats provide both an opportunity cost to the investor’s maintaining
interest in the company and a mechanism for punishing managerial misbehavior. The disciplinary eﬀect of
takeover threats is especially emphasized in Scharfstein (1988). This gives us a second empirical question.
Does the threat of takeover reduce the proportion of withdraws, s, which managers deal to
themselves? Is this eﬀect stronger under High Cash than Low Cash?
Takeover threats may also give managers incentives to form suboptimal withdraw policies. Optimal
withdraw policies leave managers with little scope to reassure investors of their dividend plans. This is
because cash reserves begin well below the point at which optimal managers begin withdrawing from their
cash reserves and make their ﬁrst dividend payments. Investors face random ending risk if they wait for cash
to accumulate and, if they are suﬃciently pessimistic about the generosity of managers, may choose to avoid
this risk by accepting the takeover bid before the optimal manager is able to make distribute dividends.
Making early, myopic withdraws provides the manager with an opportunity to signal their generosity to
investors and forestall acceptance of takeover bids. Under such a signaling outcome we would expect to see
takeover inducing myopia in Low Cash ﬁrms but not in High Cash ﬁrms.
Question 3: Does the threat of takeover cause Low Cash ﬁrms to institute myopic withdraw policies?
Figure 2: Experiment display. This is an example of the managers screen. The investors screen was identical
except that the Pay to Self and Pay to Owner sliders were absent and the blue bars representing the amount
of self dealing were not visible. In Takeover sessions, investors also had a button that, when clicked, accepted
the takeover bid.
We recruited a total of 226 George Mason University undergraduates for participation in this experiment in
September, 2004. Experiments were computerized, anonymous and lasted no more than 1 hour. Subjects
sat at visually isolated terminals where they received self paced computerized instructions. After an initial
set of instructions, subjects participated in 5 isolated practice experiments in which they were managers.
This gave subjects experience with the interface but more importantly, ample experience with the random
process governing the evolution of their cash ﬂow. Upon completing practice experiments, subjects were
given a second, shorter set of instructions, 4 randomly assigned a role (manager or investor), and randomly
and anonymously matched with another subject for the actual experiment.
During the actual experiment, managers saw the display in Figure 2. This display represented each
period as a vertical bar divided up into white, red and blue sections. The white portion represented cash
left in the company, the red portion represented cash paid out as dividends and the blue portion represented
4In the practice experiments, since subjects were acting in isolation, they were not given the opportunity to make dividend
withdraws. The second set of instructions explained the portion of the interface with which subjects made dividend withdraws,
the diﬀerence between managers and investors and, in Takeover experiments, how takeovers worked.