The economic literature about dividends usually assumes that managers are perfect agents of investors, and it seeks to determine why these agents pay dividends. Other literature about the firm assumes that managers are imperfect agents and inquires how managers’ interests may be aligned with shareholders’ interests. These two lines of inquiry rarely meet. Yet logically any dividend policy (or any other corporate policy) should be designed to minimize the sum of capital, agency, and taxation costs. The purpose of this paper is to ask whether dividends are a method of aligning managers’ interests with those of investors. It offers agency-cost explanations dividends. I.
The Dividend Problem
Businesses find dividends obvious. Boards declare them regularly and raise them from time to time or face disquiet from investors, or so they think. Many managers are sure that higher dividends mean higher prices for their shares. There is a substantial body of law that controls when board may (some-times must) declare dividends, in what amount, and using what procedures. Firms enter into complicated contracts with creditors and preferred stockholders that govern the permissible rates of payouts. Dividends are paid (and regulated) at considerable cost to the firms involved. Economists find dividends mysterious. The celebrated articles by Merton Miller and Franco Modigliani declared them irrelevant because investors could home brew their own dividends by selling from or borrowing against their portfolios. Meanwhile the firms that issued the dividends would also incur costs to float new securities to maintain their optimal investment policies. Dividends are, moreover, taxable to many investors, while firms can reduce taxes by holding and reinvesting their profits. Although dividends might make sense in connection with a change in investment policy – when, for example, the firms are disinvesting because they ate liquidating or, for other reasons, shareholder can make...
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