{"id":15574,"date":"2021-05-25T07:55:55","date_gmt":"2021-05-25T07:55:55","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=15574"},"modified":"2026-07-02T12:06:02","modified_gmt":"2026-07-02T12:06:02","slug":"effect-of-agency-costs-on-payout-policy","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/effect-of-agency-costs-on-payout-policy\/","title":{"rendered":"Effect of Agency Costs on Payout Policy"},"content":{"rendered":"<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"Paying dividends to shareholders helps resolve the agency conflict between managers (agents) and shareholders (principals) by:\",\r\n    \"answerCount\": 3,\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"The correct answer is B. Reducing the free cash available. Paying dividends reduces the amount of free cash flow under management's control, limiting the potential for managers to invest in unprofitable projects or engage in wasteful spending. This helps align management's interests with those of shareholders.\"\r\n    },\r\n    \"suggestedAnswer\": [\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Increasing the cash flow of the company.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Reducing the free cash available.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Rewarding shareholders to avoid scrutiny.\"\r\n      }\r\n    ]\r\n  }\r\n}\r\n<\/script>\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/hn2pw6Mx4OQ\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n\r\n<h2>Agency Costs and Dividends<\/h2>\r\n<p>When shareholders and managers are two separate parties, managers may have an incentive to maximize their welfare at the company&#8217;s expense by choosing negative NPV projects that expand a managers&#8217; 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.<\/p>\r\n<div style=\"margin: 18px 0;\">\r\n  <a style=\"display: block; text-align: center; padding: 14px 18px; border: 2px solid #2F5BFF; border-radius: 18px; color: #ffffff; font-weight: 600; font-size: 16px; text-decoration: none; background-color: #1a73e8;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\">\r\n    Practice CFA Level 2 agency costs and payout policy concepts with AnalystPrep\u2019s Free Trial.\r\n  <\/a>\r\n<\/div>\r\n\r\n<p>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&#8217; 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.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Paying dividends to shareholders solves the agency conflict between agents and principals by:<\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>Increasing the cash flow of the company.<\/li>\r\n\t<li>Reducing the free cash available.<\/li>\r\n\t<li>Rewarding shareholders to avoid scrutiny.<\/li>\r\n<\/ol>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is B<\/strong>.<\/p>\r\n<p>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.<\/p>\r\n<p><strong>A is incorrect. <\/strong>Paying cash dividends <em><strong>reduces<\/strong> <\/em>the net cash of a company.<\/p>\r\n<p><strong>C is incorrect. <\/strong>Shareholders will scrutinize managers when they are believed to have less information.<\/p>\r\n<\/blockquote>\r\n<p>Reading 18: Analysis of dividends and Share Repurchases<\/p>\r\n<p><em>LOS 18 (d) Explain how clientele and agency costs may affect a company&#8217;s payout policy.<\/em><\/p>\r\n\r\n<div style=\"text-align: center; margin: 30px 0;\">\r\n  <a style=\"display: inline-flex; align-items: center; justify-content: center; padding: 12px 26px; border-radius: 9999px; background: #1e5bd8; color: #ffffff; font-weight: bold; text-decoration: none;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\">\r\n    Start Free Trial \u2192\r\n  <\/a>\r\n  <p style=\"margin-top: 12px; font-size: 16px; line-height: 1.5;\">\r\n    Access CFA Level 2 study notes, practice questions, mock exams, and video lessons to strengthen your understanding of agency costs, payout policy, and corporate finance applications.\r\n  <\/p>\r\n<\/div>","protected":false},"excerpt":{"rendered":"<p>Agency Costs and Dividends When shareholders and managers are two separate parties, managers may have an incentive to maximize their welfare at the company&#8217;s expense by choosing negative NPV projects that expand a managers&#8217; span of control but generates negative&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,346],"tags":[216,372,344,368],"class_list":["post-15574","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-corporate-finance-cfa-level-2","tag-cfa-level-2","tag-clientele-effect-and-agency-costs","tag-corporate-finance","tag-reading-21analysis-of-dividends-and-share-repurchases","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.6 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Agency Costs and Payout Policy | CFA Level 2<\/title>\n<meta name=\"description\" content=\"Learn how agency costs, free cash flow, and dividend policy influence corporate payouts and shareholder value. 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