Debt Versus Dividend Commitments with Simultaneous Moral Hazard and Adverse Selection

Recent research illustrates how cash flow commitments can mitigate both adverse selection and moral hazard problems. Debt commitments typically dominate dividend commitments due to stronger penalties and or tax advantages. This paper illustrates a previously unrecognized benefit of dividends based on greater flexibility in managerial incentive contracts. We show how this additional flexibility improves the shareholders' ability to control simultaneous hidden knowledge (adverse selection) and hidden actions (moral hazard).