Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

Agency Cost and Signalling Models of Payout

There are several non-tax market imperfections that may make corporate payout decisions relevant. This

section begins by describing how agency costs (misaligned incentives between managers and stakeholders)

can lead to a positive role for payout activities. We concentrate on the agency cost/contracting model of

dividends (or, more simply, the agency cost model).

Agency Cost/Contracting Model

The agency cost/contracting model assumes that companies begin paying dividends in order to overcome

the agency problems resulting from a separation of corporate ownership and control. In privately held

companies with tight ownership structures, there is little separation between ownership and control.

Because agency problems in these companies are minimal, dividends are not very important. Even

after a company goes public, it rarely begins paying dividends immediately, because ownership remains

concentrated for several years after an IPO. Eventually, ownership becomes more widely dispersed as

companies raise new equity capital and as the original owners diversify their holdings. With dispersed

ownership, few investors have the incentive or the ability to monitor corporate managers, so agency

problems can become severe in large, mature companies that generate substantial free cash flow.

Managers naturally face temptation to hoard this cash, possibly even spending it on perquisites

or negative-NPV projects. Investors understand these temptations, and will pay a low price for

management-controlled companies that hoard excessive amounts of cash. In contrast, shareholders

pay higher prices for companies with more responsive managers who commit to pay out free cash flow

by initiating dividend payments (or by aggressively repurchasing shares). This model thus explains

why initiating or increasing dividend payments also increases share prices, at least among companies

otherwise subject to agency issues.

The agency cost model predicts that dividend-paying companies are older, larger and generate more

cash than non-paying companies. It also predicts that dividend payers have fewer growth opportunities.

The data for US companies is consistent with these predictions. If we compare US companies that pay

dividends with companies that do not, we find that: (1) the average market value of dividend payers

is much greater than that of non-payers; and (2) payers grow much more slowly. The average age of

dividend payers is more than twice the average age of non-payers.

agency cost/contracting

model

A theoretical model that

explains empirical patterns

in dividend payment and

share repurchase data based

on the belief that paying

dividends allows a company

to overcome agency problems

between managers and

shareholders

EU COMPANY PAYOUT POLICY SURVEY EVIDENCE

Von Eije and Megginson (2008) studied the payout

policies of companies in the 15 nations of the

European Union (EU) for the period 1989–2006.

They found that the fraction of European companies

paying dividends declined during this period,

whereas the total value of dividends and repurchases

increased. Those patterns mirror what happened

in the United States during the same period. The

figure below also shows that in Europe (as in the US),

share repurchases grew more rapidly than dividends,

although repurchases in Europe accelerated much

later than they did in the US.

finance in practice

Would you recommend that a

company establishes a payout

policy by initiating a dividend or

by starting a share repurchase

program?

thinking cap
question