Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

15- 4f DIVIDEND PAYMENTS AS SOLUTIONS TO AGENCY

PROBLEMS

When companies are small and growing rapidly, they not only have tight ownership structures, but they

also tend to have many profitable investment opportunities. These growth companies can profitably

use all the cash flow that they generate internally. Thus, they have no reason to pay cash dividends. In

time, successful growth companies establish secure, often dominant, market positions. They begin to

generate operating cash flows that are much larger than the amounts needed to invest in the remaining

positive-NPV investment opportunities open to them. Managers of companies with cash flow in excess

of that needed to fund all positive-NPV projects should begin to pay dividends to ensure that they will

not invest that cash flow in negative-NPV projects. However, managers may prefer to retain cash and

spend it, because of the increased status attained from running a larger (though not necessarily more

valuable) company.

If managers are given the proper incentives, it is believed that they will initiate dividend payments

as soon as the company begins generating excess cash flow. Managerial contracts that tie compensation

to the company’s share price performance are designed to ensure that managers pay out excess cash

flow rather than invest it unwisely. The larger the excess cash flow generated, the larger the dividend

payout should be. This is the essential prediction of what is known as the agency cost/contracting model

of dividend payments, which was introduced in Section 15-3b. The central predictions of this model

are threefold. First, it predicts that dividend initiations and increases should be viewed as good news

by investors, and thus should lead to share price increases upon announcement. Second, the agency

cost model predicts that companies (and industries) that generate the largest amounts of excess cash

flow should also have the highest dividend payout ratios. Finally, this model predicts that managerial

compensation contracts will not only be designed to entice managers to pursue a value-maximising

dividend policy, but will also be effective.

Kenneth Eades, University

of Virginia

‘It’s an earnings story,

not a dividend story.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

COURSEMATE
SMART VIDEO

12 In what way can managers use dividends to convey pertinent information about their companies

in a world of asymmetric information? Why would a manager choose to convey information via a

dividend policy? Is there evidence supporting or refuting the informational role of dividends?

13 Why is it difficult for a company with weaker cash flows to mimic a dividend increase undertaken by

a company with stronger cash flows?

14 According to the residual theory of dividends, how does a company set its dividend? With which

dividend policy is this theory most compatible? Does it appear to be validated by actual corporate

dividend payment data?

CONCEPT REVIEW QUESTIONS 15-4