Explain how dividend payments serve to reduce agency costs between corporate managers and shareholders.
Although managers may be looking out for stockholders in any conflict with bondholders, managers may pursue selfish goals at the expense of stockholders in other situations. For example, managers take on pet project with negative NPVs, or simply not work hard. Managers find it easier to pursue this these selfish goals when the firm has plenty of free cash flow. One cannot squander fund if the funds are not available in the first place. And that is where dividend come in. several scholars have suggested that the boards of directors can use dividends to reduce agency costs. By paying dividends equal to the amount of “ surplus” cash flow, a firm can reduce management ability to squanders the firm’s resources. Happened with managers of large mature firms that are mostly equity financed may have incentive to accept negative NPV projects. If inactive or passive stockholders primarily own the firm, then the problem is exacerbated. Paying out high dividends reduces the amount of cash flows available to managers and will also reduce agency costs.
Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition.
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