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Two Agency-Cost Explanations of Dividends
By FRANK H. EASTERBROOK*
650
VOL. 74 NO. 4 EASTERBROOK: A GENCY-COST EXPLANA TIONS OF DIVIDENDS 651
dividends. More frequentlythey issue new Other arguments are only slightly more
debt, often in the form of bank loans that plausible. Consider the argumentthat divi-
are almost invisible to finance economists. dends "signal"the well-beingof the firm to
Why does this occur? investors and so promote confidence (and,
The problemwith the irrelevanceproposi- one supposes,higherstock prices and a flow
tion is that dividends are costly yet ubiq- of investmentcapital).8The problemhere is
uitous. Somethingcauses them. Even if most that it is unclearjust what dividendssignal,
investors are irrational most of the time, how they do so, or why dividendsare better
dividends would go away if their costs ex- signals than apparently cheaper methods.
ceeded theirbenefitsto investors.Firms that Firms could and do issue disclosuresof their
reduced payouts would prosper relative to prospectsand profits.True,investorsmay be
others; investors who figured out the truth disinclined to believe the self-servingstate-
also would prosper relative to others; and ments of managers about the firms' en-
beforelong-certainly beforenow in light of deavors,but managers'usualresponseto this
the large costs of floatingnew capital issues is to hire outsiderswho examine the firms'
and the large differences between income books and other materials and opine on
and capitalgains tax rates-dividends would whether the managersare telling the truth.
be infrequentoccurrencescharacterizingfail- These outsiders work for many firms and
ing or disinvestingfirms. acquirereputationalcapitalso largethat they
The existence of dividends despite their becomeunbribable.No firmcould offerthem
costs has inspireda searchfor explanations. enough for a false (or slipshod) verification
Some of the efforts have been obvious to make up for their losses on businesswith
failures.Take the argumentthat investments other firms. Auditors serve this function
are risky and that dividends hedge against yearlyor more often;9evenjudges may serve
the possibilitythat the firmswill go bankrupt this function in suits chargingthe managers
before distributingthe saved-upassets to the with making false statements or omitting
shareholders.The argumentgoes: investors materialfacts.
value a steady streamof dividendsover the Dividends would be desirableonly if they
uncertainprospectof a largereturnwhen the added to the efficacy of these methods of
firmsliquidateor are sold as going concerns disclosure.The beautyof a "signal"is that it
and the investorsare cashed out, and firms is self-verifying.People believe the signal
pay dividends to cater to that preference. because sending the message is rational for
The problem here is that dividends are the signaller only if the message is or is
matched by reinvestments:so long as divi- believed to be accurate.Thus one could say
dends do not affect firms' investmentpoli- that a Ph.D. from the Universityof Chicago
cies, they do not representany withdrawalof is a good signal of intelligenceand diligence
capital from risky ventures. New investors (two notoriouslyhard-to-verifyqualities)be-
bear the risk that the dividend-receivingin-
vestors avoid, and these new investorsmust
be compensated.The new investorsmay well times said that the bird-in-the-handargumentfails be-
cause one may get cash for consumption(or to put in
turn out to be the old ones; shareholdersdo the bank) by selling stock as well as by waiting for
not usually use the dividendsfor consump- dividends.This is not a good refutation,becauseif the
tion or to purchase Treasurybills. If they lack of dividendsputs investeddollarsat unacceptable
reinvestthe proceedsin the same or a differ- risk, shareswill fetch less in the marketon a no-divi-
dend policy thanotherwise,and investorswill be poorer
ent firm, they commit their cash (less taxes than they wouldbe if dividendswereplentiful.
paid) to the same risks as if there had been 8See, for example, Bhattacharya;Nils Hakansson
no dividends. In sum, there is no bird-in- (1982); StevenRoss (1977). CompareMillerand Rock:
the-handeffect unless the firm also changes in this model,dividendsmaypermitinferenceof sources
its investment policy.7 and uses of funds;this achievesmanyof the effectsof a
signallingmodelbut by directrevelationor inference.
9See Linda DeAngelo (1981): using the auditor's
7CompareM. J. Gordon(1959), with MichaelBren- "reputationalbond" to show that largerauditorspro-
nan (1971)and SudiptoBhattacharya
(1979).It is some- vide betterquality.
652 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984
they do not give away wealth to bond- contnbutors of capital are very good moni-
holders.The shareholderswould prefer that tors of managers.The firm'sexisting inves-
managersgo to the limit authorizedby con- tors can influencethe managers'actionsonly
tract in imposing risks on the firm's credi- by voting (which suffers from a collective
tors. Yet it is hardto give managersthe right choice problem) and by selling. Purchasers
incentivesto do this. There is little one can of stock will pay no more than the value of
do to get rid of their risk aversion.They will futureprofitsundercurrentmanagementun-
remain undiversified,because of the nature less they are prepared to wage a takeover
of their human capital, no matterwhat; in- contest of some sort, which can be very
deed, the lack of diversificationin managers' costly. Managersof firms with fixed capital
holdingshas other benefits.20Unless thereis structuresmay well have substantialdiscre-
some form of ex post settling up with tion to be slothful, consume perquisites,or
managers,which will be difficult(costly) to otherwisebehavein theirown interestsrather
achieve, shareholders'payoffs will be lower, than the investors'interests.
with consequencesfor the level of invest- New investors do not suffer under the
ment. collectivechoice disabilitiesof existinginves-
Both the monitoring problem and the tors. They can examine managers'behavior
risk-aversionproblem are less serious if the before investing,and they will not buy new
firm is constantly in the market for new stock unless they are offered compensation
capital. When it issues new securities, the (in the form of reduced prices) for any
firm's affairswill be reviewedby an invest- remediable agency costs of management.
ment banker or some similar intermediary Managerswho are in the capitalmarketthus
acting as a monitorfor the collectiveinterest have incentivesto reducethose agency costs
of shareholders,and by the purchasersof the in order to collect the highestpossible price
new instruments.The same occurswhen the for theirnew instruments.New investorsare
firm issues new debt, includingbonds, com- betterthan old ones at chiselingdown agency
mercial paper, and syndicated bank loans. costs.
Managers who need to raise money con- Of course,new investorsneed information,
sistently are more likely to act in investors' and that may be hard to come by. Neither
interests than managers who are immune auditors nor the managers themselves are
from this kind of scrutiny.Moreover,when it perfectly reliable unless there is a foolproof
issues new securities,the firmcan adjustthe legal remedy for fraud.2"Other forms of
debt-equityratio (and obtain a new rate of informationgathering,such as shareholders'
interest for its debt) so that neither share- inquiries and stock brokers' studies, suffer
holders nor bondholders are taking ad- from the problem that none of the persons
vantageof the othergroup.(It can, of course, makinginquirycan capturevery much of the
make this adjustmentin other ways, includ- gain of this endeavor,and thus therewill be
ing making more frequenttrips to financial too little informationgathered.There would
marketsfor smaller sums of new cash, but be savingsif some informationgatherershad
becauseflotationcosts decreasewith the size largerproportionatestakes,and if the verifi-
of the offering,such alternativesmay be more cation of informationcould be accomplished
costly than combining infrequent flotation at lower cost. Underwritersof stock and
with dividends.) large lenders may supply the lower-cost
The principalvalue of keeping firms con- verification.These firmsput their own mon-
stantly in the marketfor capital is that the ey on the line, and any informationinferred
from this risk-takingbehaviorby third par-
ties may be very valuableto other investors.
20DouglasDiamond and Robert Verrecchia(1982). This form of verificationby acceptanceof
Fama and Jensen(1983a)offer a substantiallydifferent
treatment,in which they do not employ the artifactof
the firmas risk-averse"principal."Managersthen bear
risk in the form of undiversifiedportfoliosin order to 21See StanfordGrossman(1981);myself and Fischel
inducereductionsin otheragencycosts. (1983b).
VOL. 74 NO. 4 EASTERBROOK: A GENCY-COST EXPLANA TIONS OF DI VIDENDS 655
risk is one of the savings that arise when imperfectlyin these contracts,so there will
dividendskeep firmsin the capitalmarket.22 alwaysbe some need for ex post adjustments
The role of dividends in starting up the and supervision,and dividendsplay a role in
monitoringprovidedby the capitalmarketis these adjustments.
easy to see. An example of the role of divi- This obviously is not altogetherdifferent
dends in makingrisk adjustmentsmay help. from informationor signallingexplanations
Supposea firmhas an initialcapitilizationof of dividends. One could recharacterizepart
100, of which 50 is debt and 50 equity. It (but not all) of this treatmentas an assertion
invests the 100 in a project.The firm pros- that investmentbankersand other financial
pers, and earningsraise its holdings to 200. intermediariessend signals to investors by
The creditorsnow have substantiallymore putting their reputations(and, in underwrit-
security than they started with, and corre- ten offerings,money) on the line and certify-
spondinglythe residualclaimantsare paying ing that the new securitiesare backedby the
the creditorsa rate of interest unwarranted representedearningspotential.The informa-
by currentcircumstances.They can correct tion interpretationof this agency-costtreat-
this situation by paying a dividend of 50 ment at least offers a plausible explanation
while issuing new debt worth 50. The firm's why dividends (rather than, say, earnings
capital continues to be 200, but the debt- announcements)carry essentialinformation.
equity ratio has been restored,and the inter- There is a further problem because the
est rate on the original debt is again ap- explanationsI have offered are not unique
propriateto the creditors'risk.23 explanations of dividends. Nothing here sug-
Expected, continuing dividends compel gests that repurchasesof shareswould not do
firms to raise new money in order to carry as well as or better than dividends. The
out theiractivities.They thereforeprecipitate issuanceof debt instrumentsin series,so that
the monitoringand debt-equityadjustments payments and refinancingsare continuous,
that benefit stockholders. Moreover, even servesthe same functionas dividends.I have
when dividendsare not accompaniedby the "explained"only mechanismsthat keep firms
raisingof new capital, they at least increase in the capital market in ways that insti-
the debt-equityratio so that shareholdersare gate consistentmonitoringand consistentre-
not giving (as much) wealth away to bond- adjustmentof the risk amonginvestors.
holders. In other words, dividends set in The explanationI have offeredalso is open
motion mechanismsthat reduce the agency to the objection, along the lines of Fischer
costs of managementand that prevent one Black (1976), that shareholder-creditor con-
group of investors from gaining, relative flicts may be resolved by negotiation after
to another, by changes in the firm's for- any change in the fortunesof the firm. The
tunes after financialinstrumentshave been investorscould agreeto new payoffsor shares
issued.24 The future is always anticipated of control ratherthan to a dividendpolicy.
This may well be true, but such ex post
negotiationraisesa bilateralmonopolyprob-
22One thus cannot treat it as paradoxicalthat in
raisingcapital firms use investmentbankersat a cost lem, and the costs of the negotiationcould
greaterthan the firmwould incur in raisingcapitalvia be substantial even if (contrary to my
rights offerings or other non-intermediateddevices. assumption)therewere no agency problems.
CompareRobertHansenand John Pinkerton(1982). Unless ex post negotiationis very costly, the
23Somecases containan implicitrecognitionof this
functionof dividends.For example, Randallv. Bailey,
23 N.Y.S.2d 173 (N.Y. Sup. Ct. 1940), aff'd mem., 262
App. Div. 844, 29 N.Y.S.2d 512 (1st Dep't 1941), aff'd, that dividendsare beneficialto equity holdersbecause
288 N.Y. 280, 43 N.E.2d 43 (1942)(permittingdividend they force managersconstantlyto obtainnew capitalin
out of unrealizedappreciation,financedby new debt). competitive markets. Fama and Jensen (1983b, pp.
24This explanationof dividendsis closely relatedto 13-15) also treat debt as a mechanismfor regulating
the one Grossmanand OliverHart(1982)offerfor debt. agencycosts, althoughtheirargumentis not the sameas
They say that debt is desirableto equity holderspre- that of Grossmanand Hart. See also Saul Levmore
ciselybecauseit createsbankruptcycosts, thusinducing (1982, pp. 70-71). Thereis a familyresemblanceamong
managersto take extra care. I say, in parallelfashion, all of these arguments.
656 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984
market, where monitoring of managers is DeAngelo, LindaE., "Auditor Size and Audit
availableat lower cost, and may be useful in Quality," Journal of Accounting and Eco-
adjustingthe level of risk takenby managers nomics, July 1981, 3, 183-99.
and the differentclassesof investors.Suchan Diamond,DouglasW. and Verrecchia,RobertE.,
explanationoffers a hope of understanding "Optimal Managerial Contracts and Equi-
why firms simultaneouslypay out dividends librium Security Prices," Journal of Fi-
and raisenew funds in the capitalmarket.It nance, May 1982, 37, 275-87.
does not, however,explaindividends(as op- Easterbrook,Frank H., "Insider Trading, Se-
posed to the set of all devices that have the cret Agents, Evidentiary Privileges, and the
effect of keepingfirmsin the capitalmarket), Production of Information," Supreme
and it will be difficultto test. Court Review, 1981, 309-65.
and Fischel, Daniel R., "Auctionsand
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