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Two Agency-Cost Explanations of Dividends Author(s): Frank H. Easterbrook Source: The American Economic Review, Vol. 74, No. 4 (Sep., 1984), pp. 650-659 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1805130 . Accessed: 10/05/2011 07:59
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agency. 6For example. EASTERBROOK* The economic literatureabout dividends usually assumes that managers are perfect agentsof investors. 13).their appearto. Merton Miller. of I.Dennis Carlton.1111 East 60th IL Street. Daniel Fischel.6Yet the payment simultaneousor near-simultaneous of dividends and raising of new capital are common in business.taxable to many investors. Myron Scholes. all the same. The purpose of this paper is to ask whether dividends are a method of aligning managers' interests with those of investors. shareholders can make better use of the money than managers-they are all cost and no benefit in the remainingcases of invariant investmentpolicies.for a description the legal rules. It offers agency-costexplanations dividends. economicsupportfor current 650 .the firmsare disinvesting are liquidatingor. and do not dividendpolicy. for other reasons. extend the irrelevance Millerand Scholesarguethattaxesneednot.Compare Miller and Myron Scholes(1982). He does not however.and using what procedures. dends and raisecapitalsimultaneously 'One meetingplace is Michael Rozeff (1982). determine analysis does not show why there are dividendsin a worldof costly flotation.Meanwhilethe firms that issued the dividends would also incur costs to float new securitiesto maintaintheir optimal investmentpolicies.3Dividends cost are paid (and regulated)at considerable to the firmsinvolved.JosephStiglitz(1974).Chicago.4 Dividends are. Although dividends might make sense in connection with a change in investmentpolicy-when. for exbecausethey ample. 4See Miller and Modigliani(1961).while firms can reduce taxes by holding and reinvesting their profits. who and suggeststhatdividends agencycosts are relatedand offers a test showingthat dividendsdependin part on the fraction of equity held by insiders. of 2SeeBaylessManning (1981). also Modigliani and Miller(1958). Boards declare them regularlyand raise them from time to time or face disquietfrom investors.by which dividends provide any mechanism.Otherliterature about the firm assumes that managers are imperfect agents and inquires how managers' interests may be aligned with shareholders'interests. moreover.' Dividendsarehardenoughto explainwhen they occur in isolation.2 enter into complicatedcontractswith creditors and preferredstockholdersthat govern *Universityof ChicagoLaw School.for an argument this effect modelby considering that modifiesthe M-M irrelevance taxes and uncertainty.and it seeks to determine why these agentspay dividends. 60637. The Economistsfind dividendsmysterious.There is a substantialbody of law that controls when boards may (sometimes must) declare dividends. to 5SeeModigliani (1982). and Alan Schwart7 for helnful comments on earlier drafts.I thankDouglasBaird. TheDividend Problem Businessesfind dividendsobvious.EugeneFama. or so they think. MichaelJensen.and taxationcosts.p.Millerand Kevin Rock: "It wouldbe uneconomicas well as pointless"for firmsto pay divi(1982. in what Firms amount. and the consequentraising of capital control agency of costs. I discusssome mechanisms this sort below.Kose 3See CliffordSmithand JeroldWarner John and AvnerKalay(1982). a combination of dividends and simultaneousraising of new capital is downrightinexplicable.WilliamLandes.Two Agency-Cost Explanations of Dividends By FRANK H. Many managersare sure that higherdividendsmean higherprices for their shares.HarryDeAngelo. celebrated articles by Merton Miller and Franco Modiglianideclaredthem irrelevant becauseinvestorscould home brewtheirown dividends by selling from or borrowing against their portfolios.CompareVictor Brudney(1980) callingfor with DanielFischel(1981)offering morelegalregulation legal rules.Walter Blum. These two lines of inquiry rarely meet. Saul Levmore. Sometimesfirms issue new stock at or around the time they pay (1979). the permissiblerates of payouts.' Yet logically any dividend policy (or any other corporatepolicy) should be designed to minimizethe sum of capital. applyingtheirearlieranalysis(1978) to hypothesisto a worldwith taxes.
Firms that reduced payouts would prosper relative to others. Why does this occur? The problemwith the irrelevance proposition is that dividends are costly yet ubiquitous.7 7Compare J. or why dividendsare better signals than apparently cheaper methods. 74 NO.but managers' usualresponseto this is to hire outsiderswho examine the firms' books and other materials and opine on whether the managersare telling the truth. there is no bird-inthe-handeffect unless the firm also changes its investment policy.dividendsmaypermitinference sources of and uses of funds. from the Universityof Chicago is a good signal of intelligenceand diligence (two notoriouslyhard-to-verify qualities)betimes said that the bird-in-the-hand argumentfails because one may get cash for consumption to put in (or the bank) by selling stock as well as by waiting for dividends.The beautyof a "signal"is that it is self-verifying. Somethingcauses them. Even if most investors are irrational most of the time. and beforelong-certainly beforenow in light of the large costs of floatingnew capital issues and the large differences between income and capitalgains tax rates-dividends would be infrequentoccurrences characterizing failing or disinvestingfirms. investorswill be poorer and than they wouldbe if dividendswereplentiful. Some of the efforts have been obvious failures. they commit their cash (less taxes paid) to the same risks as if there had been no dividends.This is not a good refutation. CompareMillerand Rock: in this model. 4 EASTERBROOK: A GENCY-COST EXPLANA TIONS OF DIVIDENDS 651 dividends.It is some- Other arguments are only slightly more plausible. . with MichaelBrenM.this achievesmanyof the effectsof a signallingmodelbut by directrevelation inference. and these new investorsmust be compensated. Gordon(1959). Dividends would be desirableonly if they added to the efficacy of these methods of disclosure. The problem here is that dividends are matched by reinvestments: long as diviso dends do not affect firms' investmentpolicies. New investors bear the risk that the dividend-receiving investors avoid. and firms pay dividends to cater to that preference. one supposes. More frequentlythey issue new debt. Consider the argumentthat dividends "signal"the well-beingof the firm to investors and so promote confidence (and.8The problemhere is that it is unclearjust what dividendssignal. In sum. Nils Hakansson 8See. becauseif the lack of dividendsputs investeddollarsat unacceptable risk. These outsiders work for many firms and acquirereputational capitalso largethat they becomeunbribable.VOL. StevenRoss (1977).higherstock prices and a flow of investmentcapital).D. If they reinvestthe proceedsin the same or a different firm. investors who figured out the truth also would prosper relative to others.investorsmay be disinclined to believe the self-servingstatements of managers about the firms' endeavors. nan (1971)and SudiptoBhattacharya (1979). Bhattacharya.The argumentgoes: investors value a steady streamof dividendsover the uncertain prospectof a largereturnwhen the firmsliquidateor are sold as going concerns and the investorsare cashed out.Take the argumentthat investments are risky and that dividends hedge against the possibilitythat the firmswill go bankrupt before distributing saved-upassets to the the shareholders. often in the form of bank loans that are almost invisible to finance economists. The existence of dividends despite their costs has inspireda searchfor explanations. The new investorsmay well turn out to be the old ones.True. Auditors serve this function yearlyor more often.People believe the signal because sending the message is rational for the signaller only if the message is or is believed to be accurate. they do not representany withdrawal of capital from risky ventures. firmcould offerthem No enough for a false (or slipshod) verification to make up for their losses on businesswith other firms.Thus one could say that a Ph. (1982). for example. dividends would go away if their costs exceeded theirbenefitsto investors. shareswill fetch less in the marketon a no-dividend policy thanotherwise. or 9See Linda DeAngelo (1981): using the auditor's "reputational bond" to show that largerauditorsprovide betterquality. how they do so. Firms could and do issue disclosuresof their prospectsand profits.9evenjudges may serve this function in suits chargingthe managers with making false statements or omitting materialfacts. shareholders do not usually use the dividendsfor consumption or to purchase Treasurybills.
Man12See Fischer Black and Scholes (1974) and Alan Auerbach(1982).no signalis possible. for The taxed groupwould preferto take profits as capitalgains. See also.Why do most firmspay significantdividends. 13Martin Feldstein and JerryGreen (1983) do not overcomethis problemwith clientelemodels."2 It is much harder. Because the managersare not the residual claimants to the firm's income stream. there may be a substantialdivergence betweentheirinterests and those of the other participants.652 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 cause persons of inferiorintellect could not obtain one.Some equilibrium would develop in which firms adopted different payout " Only "may be" instead of "is" because the message may be self-justifying. because they dissipate cash and induce firms to float new securities. Prosperousfirms may withhold dividends because internal financing is cheaper than issuingdividendsand floatingnew securities. TwoExplanations The dividend puzzle has been stated as: "what is the effect of a change in cash dividends paid.so the message they convey may be ambiguous. With largenumbersof firmsan investorcan get plenty of diversification without differentialdividend policies. and the apparentmarketingsuccess of the firmwould do as well in verifyingthe managers' tales. Worse. The persistentreportsof auditors and securities dealers. its securities' prices. policies to cater to the differentclienteles. 14Richard Brealeyand StewartMyers(1981.Theyuse a two-firm.prospering are not irrational for poorly managed or failing firms. because the irrelevancehypothesis and the growingbody of evidencesay that dividends do not matterso long as the firm'sfinancing and investmentpolicy is unaffected. RobertShiller(1981).given the costs of paying them(and raisingnew capital). and their managers may choose dividendsas a method of accomplishing this. to use clientele effects to demonstratewhy the currentdividend structure exists. though.but that they pursuetheir own interests when they can. Let us suppose that managersare not perfect agents of the other participantsin the corporateventure. suggest that it is appropriateto ask a differentquestion: "what is the effect of a consistentpolicy of paying dividends?" Thisquestionleadsto whatcould be called a naive explanationof dividends. is easy enough to It see that if some investorsare in differenttax positions from others (for example. (This is consistent with both the finding that dividends are poor predictors of future net earnings and the finding that stock prices are poor predictors of future dividends. 324. for example. but a firmwith a long record of prosperity also would not need the verificationavailablefrom the dividend signal.But see Millerand Scholes(1982).'0Unless the cost of issuingdividendsis uniformly lowerfor prosperous firms. "Stephen Penman (1983) finds that knowledgeof dividendsadds little or nothingto earningsforecastsas predictorsof future earnings. without steady trading.two-holder model in whichportfoliodiversification. The explanations based on clienteleeffects also are unsatisfactory. The two-firmassumptiondrives the model.The existence of dividendsin the face of this.dependson differential dividend policies. . the untaxedgroupwould be indifferent.the differentgroups will have differentpreferences dividends. and despite the costs of paying them out and raising new money. given the firm's capitalbudgeting and borrowing decisions?"'4 This statementof the problemmakesit insoluble. Dividends exist because they influence the firms' financing policies.and given that all investors either prefer capital gains or are indifferent between dividends and capitalgains?'3 II.such firms should disinvest or liquidate. italics in original). Quite the contrary. in the Miller and Rock as model.They managed. But dividends do not directly revealthe prospectsof the firms. some hold tax-shelteredfunds while others are taxed at ordinaryrates).)" Doubtless only a prosperingfirm can continue to pay dividends year in and year out. dividends do not distinguish wellfirmsfromothers. Someone who observes an increase in the dividend has no very good way to tell whether this signals good times or bad. p.
yet bondholdersbear part of the risk of failure). 352-53). worse."5 advantage.bonding.from shareholdersto debtholders. Bengt Holmstrom(1982). It shareholders. See also George Handjinicolaou Kalay(1982):stressing and role of dividends in adjusting risk between bondholders and stockholders. The little of the gain. Because shares are widely not only by alteringits mix of projects. debtholdersconsider this in deciding ee. Shareholderswould be lower the ratio of debt to equity. the lower wealthier if there were some person. 4 EASTERBROOK: AGENCY-COST EXPLANATIONS OF DIVIDENDS 653 as risk preferrers. ing.If the firmsdo poorly or. with my article(1981. . 19Johnand Kalay also stress this.have a substan."6Although a monitor-share. who monitored managers on share. Just as sion will magnifythis concern. so that any of the gains to bondholders. pp. Eugene Fama (1980). bondholderswant to limit dividends. given the existence of debt. Shareholders holders want to increase dividends to the have the opposite preference. Financingprojjobs and any wealth tied up in their firms' ects out of retained earnings-if unanticstock.But the question is not whether the riskiness of projects can be controlled One form of agency cost is the cost of monitoring of managers.17The investors. concludingthat dividendsdo not appear to cause unanticipated losses to bondholders. no one shareholder captureeven a can also by altering its debt-equity ratio. 1983a) for discussionsof the extent to which legal rules addressthis problem. 17SeeJensen and Meckling (pp. and ex post readjustments that give managersthe incentive to act as better agents. managers can A second source of agency costs is risk control the amount of risk. One way they can do this is by pickinga dividendpolicy. the managerswill lose their cape the contracted-for risk. so sharereturn than riskier ventures.VOL. rather.what rate of interestto demand. the versifiable with respectto any one firm's debt-equityratio will fall.they also adjust the rate of interestthey demand. StevenShavell(1979).Riskier venextent possiblein orderto avoid being taken tures enrich shareholdersat the expense of advantageof by bondholders.with diversified portfoliosof stocks. including monitoring. 330-38).whethercosts of control(including action ensures that shareholdersundertake the costs of controland residualagencycosts) too little of it. 74 NO. and theirpersonalrisk aver.again. shareholdersprefer to take the maximum investors.This is costly for throughindenturesor other legal devices. bonding. holders'behalf.and Alan Marcus(1982). 349-50.who their firms.'9 creditors(because shareholdersdo not pay Shareholderstherefore would like to induce managersto take more risks.and other participantswill find it advantageousto set up devices.Once again. "8Thisis one possible argumentfor permittinginsider trading.the lower the managers'risk and the greater tial part of their personalwealth tied up in the boon bestowed on the debtholders.dividends. investors.though.and shareholders wouldwant managers behave to agers. If aversion on the part of managers. creditors Of recognize this and try to control it in advance through bond indentures and other instruments. comthe chance of bankruptcyof the firm.Managers. JLE Symposium (1983). receive their contracted-forinterest but esgo bankrupt. The lower it falls. The costs of monitoring. he would reap gains only in proportion Managerscan change the risk of the firm to his holdings. Managersthereforewill be concerned ipated by bondholders-transfers wealth about total risk. risk ventures. and the problem of collective is.can be reduced by a method that includes holderwould incur the full costs of monitor. 16Seemy articleswith Fischel (1982."8 course.but held. managersfirst issue debt and then finance will be concerned only about any nondinew projects out of retained earnings. CompareHenry Manne (1966) and Dennis Carlton and Fischel (1983).vent advantage-taking shareholders once ects that are safe but have a lower expected a rate of interest has been set. and the residuallosses from slippage are agency costs borne by 15MichaelJensen and William Meckling (1976).Debtholdersassumethat given the limits set by their contracts. if other compensation schemes are too costly. Once parable to the bondholders'indenturetrust.to preThe risk-averse managers by may choose proj.
includingbonds. contnbutors of capital are very good monitors of managers. Purchasers of stock will pay no more than the value of unfutureprofitsundercurrentmanagement less they are prepared to wage a takeover contest of some sort. no matterwhat.The shareholders managersgo to the limit authorizedby contract in imposing risks on the firm's creditors. Yet it is hardto give managersthe right incentivesto do this. issues new securities. by the purchasers the The same occurswhen the new instruments. Managers who need to raise money consistently are more likely to act in investors' interests than managers who are immune when it from this kind of scrutiny. the lack of diversification managers' Unless thereis holdingshas other benefits. of course.which will be difficult(costly) to payoffs will be lower. which can be very costly." the firmas risk-averse portfoliosin order to risk in the form of undiversified in inducereductions otheragencycosts.These firmsput their own money on the line.The firm'sexisting invesactionsonly tors can influencethe managers' by voting (which suffers from a collective choice problem) and by selling.and if the verifilargerproportionate cation of informationcould be accomplished at lower cost.such as shareholders' inquiries and stock brokers' studies. Of course. which they do not employ the artifactof Managers then bear "principal. achieve. Neither auditors nor the managers themselves are perfectly reliable unless there is a foolproof legal remedy for fraud. commercial paper. This form of verificationby acceptanceof (1981).and thus therewill be too little informationgathered.2"Other forms of informationgathering.) The principalvalue of keeping firms constantly in the marketfor capital is that the (1982). of their human capital. suffer from the problem that none of the persons makinginquirycan capturevery much of the gain of this endeavor. but becauseflotationcosts decreasewith the size may be more of the offering. New investors do not suffer under the collectivechoice disabilitiesof existinginvestors.new investorsneed information. the firm's affairswill be reviewedby an investment banker or some similar intermediary acting as a monitorfor the collectiveinterest of and of shareholders. Managerswho are in the capitalmarketthus have incentivesto reducethose agency costs in order to collect the highestpossible price New investorsare for theirnew instruments. 20DouglasDiamond and Robert Verrecchia different Fama and Jensen(1983a)offer a substantially in treatment.20 some form of ex post settling up with managers.There would had be savingsif some informationgatherers stakes. betterthan old ones at chiselingdown agency costs. They can examine managers'behavior before investing. make this adjustmentin other ways. firm issues new debt.and they will not buy new stock unless they are offered compensation (in the form of reduced prices) for any remediable agency costs of management. shareholders' with consequencesfor the level of investment. including making more frequenttrips to financial marketsfor smaller sums of new cash.They will because of the nature remain undiversified. .(It can. There is little one can do to get rid of their risk aversion. Both the monitoring problem and the problem are less serious if the risk-aversion firm is constantly in the market for new capital. and that may be hard to come by. and syndicated bank loans.such alternatives costly than combining infrequent flotation with dividends.or otherwisebehavein theirown interestsrather than the investors'interests. and any informationinferred from this risk-takingbehaviorby third parties may be very valuableto other investors.myself and Fischel 21See StanfordGrossman (1983b). consume perquisites.Moreover. When it issues new securities. inin deed. Underwritersof stock and large lenders may supply the lower-cost verification. Managersof firms with fixed capital structuresmay well have substantialdiscretion to be slothful.the firmcan adjustthe debt-equityratio (and obtain a new rate of interest for its debt) so that neither shareholders nor bondholders are taking advantageof the othergroup.654 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 they do not give away wealth to bondwould prefer that holders.
relative to another. dends in makingrisk adjustments of Supposea firmhas an initialcapitilization 100. 74 NO. of which 50 is debt and 50 equity.Y. Ct. dividends set in motion mechanismsthat reduce the agency costs of managementand that prevent one group of investors from gaining. 29 N. 4 EASTERBROOK: A GENCY-COST EXPLANA TIONS OF DI VIDENDS 655 risk is one of the savings that arise when dividendskeep firmsin the capitalmarket. earnings carry essentialinformation. aff'd mem.Y. even by when dividendsare not accompanied the raisingof new capital.Y. The firm's capital continues to be 200. Sup. Nothing here sug- of gests that repurchases shareswould not do as well as or better than dividends. 1940).2d 43 (1942)(permitting financed new debt). by changes in the firm's fortunes after financialinstrumentshave been issued. This may well be true.S.The informarepresented of tion interpretation this agency-costtreatment at least offers a plausible explanation why dividends (rather than. CompareRobertHansenand John Pinkerton of 23Somecases containan implicitrecognition this functionof dividends. rights offerings or other non-intermediated (1982). 262 App. 23 N. but the debtequity ratio has been restored. I say. and correspondinglythe residualclaimantsare paying the creditorsa rate of interest unwarranted They can correct by currentcircumstances. 844. that shareholder-creditor flicts may be resolved by negotiation after any change in the fortunesof the firm. along the lines of Fischer conBlack (1976). these adjustments. in underwritten offerings. Randallv. 280.24 The future is always anticipated 22One thus cannot treat it as paradoxicalthat in raisingcapital firms use investmentbankersat a cost greaterthan the firmwould incur in raisingcapitalvia devices. and the costs of the negotiationcould be substantial even if (contrary to my assumption)therewere no agency problems.. This obviously is not altogetherdifferent from informationor signallingexplanations part of dividends.The firm prospers. aff'd. continuing dividends compel firms to raise new money in order to carry precipitate out theiractivities. but such ex post negotiationraisesa bilateralmonopolyproblem. See also Saul Levmore among (1982. out of unrealized of 24This explanation dividendsis closely relatedto and the one Grossman OliverHart(1982)offerfor debt. pp. they at least increase are the debt-equityratio so that shareholders not giving (as much) wealth away to bondholders. the that dividendsare beneficialto equity holdersbecause constantlyto obtainnew capitalin they force managers competitive markets. Fama and Jensen (1983b. say. pp. 13-15) also treat debt as a mechanismfor regulating is agencycosts.They therefore the monitoringand debt-equityadjustments that benefit stockholders.22 The role of dividends in starting up the monitoringprovidedby the capitalmarketis easy to see.S. Moreover. Thereis a familyresemblance all of these arguments.2d 512 (1st Dep't 1941).E.For example. Div. imperfectlyin these contracts. 70-71). They say that debt is desirableto equity holdersprecosts. and earningsraise its holdings to 200. announcements) There is a further problem because the explanationsI have offered are not unique explanations of dividends. in parallelfashion. In other words. It invests the 100 in a project. by appreciation. thusinducing ciselybecauseit createsbankruptcy managersto take extra care. .and the interest rate on the original debt is again aprisk. The explanationI have offeredalso is open to the objection.2d 173 (N. The creditorsnow have substantiallymore security than they started with.I have that keep firms only mechanisms "explained" in the capital market in ways that instigate consistentmonitoringand consistentreadjustmentof the risk amonginvestors. An example of the role of divimay help. The in issuanceof debt instruments series.so that payments and refinancingsare continuous. 43 N. servesthe same functionas dividends. One could recharacterize (but not all) of this treatmentas an assertion that investmentbankersand other financial intermediariessend signals to investors by putting their reputations(and. The investorscould agreeto new payoffsor shares of control ratherthan to a dividendpolicy. dividend 288 N.Y.so there will alwaysbe some need for ex post adjustments and dividendsplay a role in and supervision. Unless ex post negotiationis very costly. this situation by paying a dividend of 50 while issuing new debt worth 50.VOL.23 propriateto the creditors' Expected.money) on the line and certifying that the new securitiesare backedby the earningspotential. Bailey. althoughtheirargument not the sameas that of Grossmanand Hart.
The "level of dividends" is itself difficult to calculate for purposes of these studies. One also could attempt to distinguishfirmswith high dividend/financing-to-assetratios from firmswith low diviratios. because an increase in dividends could be caused either by an increase in the firm's profits (implyinghigher stock prices) or by the commencementof disinvestmentas the firm has fewer profitableopportunities(implying lower stock prices). Miller earlierstudies. and only unanticipated changes could change the prices of shares. will encounter substantialdifficultyin identifyingthe time at which new capital is raised. Robert Litzenberger and Krishna Ramaswamy (1982). dividends might reduce agency costs.and it is almostimpossible to obtain data on net dividends. however. and what is one to make of a firm'sdrawing againsta line of credit arranged an earlier at time? A test also would face the problemof determiningwhich payout policies were anticipatedand which were not.new tests will raisedifficultquestionsof anticipation.It also would isolate the set of firmswhose managers werenot able to rely wholly on internally generated funds and for which. The hypothesesI offer here suggest that the securities of firms simultaneously paying dividendsand raising new money will appreciaterelativeto other securities.The hypothedend/financing-to-asset ses offered here suggest that there is some optimalratio for each firmor set of firms. This is.656 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 existingpatternof complexbond indentures that provide for most contingenciesmakes little sense. therefore. an empiricalmatter. Miller and Scholes(1982). The presence of new fund raising would indicate that dividendsdid not represent disinvestment. .25 Theseare hardto evaluate.It would be interesting to find out whether simultaneous dividendand financingchanges produce the same negative residuals sometimes found when one changes but the other does not. Ill.otherthanclienteleeffects.Becauseof the agency-cost of explanations dividends focus on constant payout policies ratherthan changes in dividends. why changesin dividendor financingpolicy may be associatedwith price reductions.Moreover. The agency-costexplanationsalso offer a plausiblereason.for it is hardto obtain a measureof unanticipated changesin the level of dividends.26 The difficulty of designing an empirical test is formidable.which suggests resorting are findingsthat new financings associated 26Existing do with price reductions not accountfor the possibility that rights offerings and below-marketunderwritten offeringswill reducethe price of stock withoutdiluting interests(and thuswithoutmaking investors' the current them worseoff).Any studyof the implications of the hypothesesI offerhere would be beset by many of the same difficulties. Earliertreatmentsof dividendsseek to explain net dividends(payouts in excess of new flotation).I thereforethinkwe must assume that in some decentlylarge numberof cases. accommodationthrough dividends and financing decisions set by the residualclaimants is cheaperthan accommodation through ex post negotiation. A test. however. and Rock. Possible Tests There have been a flurry of tests on the consequencesof dividends.because other approaches to dividends imply that firms raise capital or pay dividendsbut do not do both. 25For example. The studies have other problemsas well. studies that aggregatedividendincreasesacross the classes could show small effects even when studies the separating two reasonsfor increasewould show large ones. Some syndicated loans are not announcedto the public. It is not my purposeto offer a critiqueof the availablework.othersclaim that increasesin dividends are associated with decreasesin the pricesof shares. Finding a significant number of firms simultaneously (anotherproblemof interpretation!) paying dividends and raising new money should offer substantialsupport for the agency-costexplanations. all discussing It shouldbe possibleto reexamine data the using as a new independentvariablewhether the firmhad been in the capital marketraising new money (whetherdebt or equity) at much the same time as it was paying dividends.Some show that dividendchangesare not relatedto the price of shares. which raises the question whether the agency-cost explanations are testable.
because small increases(small changesof all sorts)in profits will be anticipated by debtholders. Only the unanticipated (relativelylarge) changes call for adjustmentsin dividendpolicy. 74 NO. Because the first function of dividends is to keep firms in the capital markets.One indirect way to examine whetherconsistent dividendsarevaluedfor theireffecton agency costs is to examinewhetherpricesappreciate more on an increase in the "regular"dividend than on an increaseof the samepresent value in "extraordinary" dividends.MichaelRozeff suggests that this occurs. The net effect may be a wash. A consistent policy uncouplesdividendsfromprofitswhile a maintaining link to the capitalmarket. Shareholders concerned only about payouts in hand value the two equally.I suggest that dividends may keep firms in the capital effects.The agency-costtreatmentpredicts that increasesin dividendslag increases in profit and are uncorrelatedwith future profits. (Asquithand effect. so it is not clear whetherany price effects will be large. if dividends contain agency costs. The lag may be substantial.28 IV.The need to find some agency-costcontroldevice increases as a firm becomes older and the originaldevices are less well adapted to the currentform of business. Of course.This offers some supportfor the thesis in the text. regular payouts are more valuable.20 cents per shareper quarter) that are not changedvery often.) dividends are increased)would be more importantexplanatory variablesthan currentor anticipated profits. Finally.we would not expect to see a very strongcorrelation betweenshort-term profits and dividends. dividends may be useful in reducing the agency costs of management. and the initiation of dividendsmay supply such a device from the capitalmarket. Evidence indicates that the regular dividend is associated with greater increasesin price (see JamesBrickley. and 28Handjinicolaou Kalayshow ambiguous . Profits would have some effect on the risk-adjustmentfunction. As such managers'claims increase.VOL. and there will be no need to make adjustments for these changes. On the otherhand. yield unambiguouspredictions about how bond prices will react to dividends.27 The agency-costexplanationshave implications for the stability of dividends over time as well. 4 EASTERBROOK: AGENCY-COST EXPLANA TIONS OF DI VIDENDS 657 to someless formalinquiries.conferringbenefits on all investors.On the one hand. we would expect to see substitutionamongagency-cost control devices. dividends would be less valuable to investorsand woulddecrease.This paper is a small step towardunderstanding whether. but past profits (which inure to debtholders'benefit unless 27PaulAsquith and David Mullins(1983) find that in there is a significant appreciation the price of stock when a firm initiates dividend payments. which are regularlyin the capital market. and with the impressionthat such firmsstart paying dividendsonly when the rate of their growth(and thus the frequencyof their trips to the capitalmarket)has been reduced. dividendsfavor investorsand expose bondholders to more risk. thereby depressing bond prices.This is consistentwith the observation that no-dividend(or low-dividend) stocks are usually "growth" firms. because all forms of controlling agencycosts are themselvescostly. agency-cost The explanations of dividends imply that dividends are worthlessin themselves. or it may not. The same sort of substitutionshould accompanyuse of other devices.but it is certainlyconsistentwith the fact that most firms have consistentpolicies (for example.we would expect to see less paid out in dividends.Thus if firms are driven to the capital market by other conditions. unanticipatedpast profitsmustbe paid out to avoidwindfallsto debtholders. Anticipated profits can be handledby an adjustment the termson of which money is raised. however. dividendskeep managers' noses to the grindstone.they Mullinstreatthe increaseas an information for do not considerotherexplanations theirfindings.One method of dealingwith agency costs is for the managers to hold substantial residual claims in the firm. bondholders anticipatethe use of dividends and the ensuing adjustmentof risk.This implicationcries out for testing. Conclusion The economics literature has yet to integrate the study of corporate finance and the theory of the firm.other things equal. do The agency-costexplanations not.1983).and how.
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