Effect of Agency Costs on Payout Policy

Agency Costs and Dividends

When shareholders and managers are two separate parties, managers may have an incentive to maximize their welfare at the company’s expense by choosing negative NPV projects that expand a managers’ span of control but generates negative cash flows. In the free cash flow hypothesis, Jensen suggests that to stop managers from choosing extravagant projects at the expense of shareholders, companies can pay out dividends to reduce free cash and focus on positive NPV projects to meet principal interest payments debt. Thus, dividend payments help solve the problem of agency costs.

Another concern for companies financed by equity and debt is that dividend payments increase the risk of companies defaulting, creating agency conflict between shareholders and bondholders. This is seen when dividend payments reduce the cash cushion available to the company for disbursement of fixed required payments to bondholders. Bond indentures include a covenant that restricts the distributions to shareholders that might impair bondholders’ position, which reduces the default risk. These covenants do not limit the level of dividends if they come from earnings and new issues of stocks.

Question

Paying dividends to shareholders solves the agency conflict between agents and principals by:

1. Increasing the cash flow of the company.
2. Reducing the free cash available.
3. Rewarding shareholders to avoid scrutiny.

Solution

The correct answer is B.

Reducing free cash flow makes it hard for managers to overspend on unprofitable projects and focus their efforts on meeting interest and principal debt payments.

A is incorrect. Paying cash dividends reduces the net cash of a company.

C is incorrect. Shareholders will scrutinize managers when they are believed to have less information.

Reading 18: Analysis of dividends and Share Repurchases

LOS 18 (d) Explain how clientele and agency costs may affect a company’s payout policy.