Paper: "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers"

Highlights:

• Payouts to shareholders reduce the resources under managers’ control, thereby reducing managers’ power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital. Financing projects internally avoids this monitoring and the possibility the funds will be unavailable or available only at high explicit prices.
• Managers have incentives to cause their firms to grow beyond the optimal size. Growth increases managers’ power by increasing the resources under their control. It is also associated with increases in managers’ compensation, because changes in compensation are positively related to the growth in sales. The tendency of firms to reward middle managers through promotion rather than year-to-year bonuses also creates a strong organizational bias toward growth to supply the new positions that such promotion-based reward systems require.
• Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows. Thus, debt can be an effective substitute for dividends, something not generally recognized in the corporate finance literature. By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increases. In doing so, they give shareholder recipients of the debt the right to take the firm into bankruptcy court if they do not maintain their promise to make the interest and principal payments.

So what does this suggest could be done to improve capital allocation? The debt solution is probably a pretty good one since it is also tax efficient. On the other hand, we are so anti-debt that it's worth looking at a couple other possibilities.

Require shareholder approval to spend funds on new capital projects. For example, an S-corp might already have a stipulation that some or all taxable earnings be dividend-ed to shareholders (so that they can meet their tax obligations). That would require management to try to raise new capital through some other means, for example a rights offering (which seems like a fair tool to use). The rights offering might be improved upon by requiring shareholder approval before implementation.

Perhaps the organizational bias towards growth could be defeated by increased profit sharing or employee ownership instead of rewarding strictly via promotion.