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In: Finance

How are agency costs related to dividend policy?

How are agency costs related to dividend policy?

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Expert Solution

Agency theory of dividends claims that the payment of dividends is one of the measures available to managers for controlling agency behaviour. Specifically, it is proposed that by inducing external monitoring, dividends reduce agency costs, although at the same time increasing the transaction costs associated with raising external funds.

The agency theory of dividend in general, and the cost minimisation model in particular, appear to offer a description of how dividend policies are determined. The variables in the original cost minimisation model remain significant with consistently signed estimated coefficients. Specifically, the constant is, without exception, positively related to the dividend policy decision, while the agency costs variable is consistently negatively related to the firms’ dividend policy. Similarly, the agency cost variable, ownership dispersion, is consistently positively related to the firm’s dividend policy, while the transaction cost variable, risk, is consistently negatively related to the firm’s dividend policy regardless of the precise proxy used. The other transaction cost proxies, the growth variables, are also mainly significant and negatively related to the firm’s dividend policy, although past growth appears to be a less stable measure than future growth.

When the firm increases its dividend payment, assuming it wishes to proceed with planned investment, it is forced to go to the capital market to raise additional finance. This induces monitoring by potential investors of the firm and its management, thus reducing agency problems. This is the theory, called the cost minimisation model. The model combines the transaction costs that may be controlled by limiting the payout ratio, with the agency costs that may be controlled by raising the payout ratio. The central idea on which the model rests is that the optimal payout ratio is at the level where the sum of these two types of costs is minimised.


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