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Dividends and agency problem

Following Jensen and Meckling (1976), a firm can be seen as a nexus of contracts. Managers, appointed by shareholders, have to act (in theory) on their behalf. If, in theory, managers have to act according to shareholders’ interests and to maximize a firm’s value, they can nevertheless behave opportunistically in various ways. As their incomes are generally a function of the firm’s size, managers can be tempted to maximize turnover (and not profits) and build empires in order to reinforce their prestige (Hubris Hypothesis of Roll, 1986). They can also be tempted to implement particular investment strategies. Insofar as their incomes depend exclusively on the company which has hired them, they may choose investment plans whose profitability/risk profile is excessively weak (conglomerate mergers for example, Amihud and Lev, 1981). The effects of such a policy are not generally in line with shareholders’ interests (Lang and Stulz, 1994). Managers can also act against shareholders’

interests, e.g. they can earn excessive wages thanks to their relationships with the Board of directors. Shareholders then will have to design methods able to control managers and to check that the latter are committed to increasing the firm’s value.

Several control mechanisms can be used to reduce and limit manager power (Charreaux, 1997), such as debt or dividends. For instance, dividends can be used as a means of control. First, if managers have to borrow funds from investors, their dividend policy will play a significant role on these investors. Second, because revenues of shareholders depend (in part) on dividends¹⁵, dividend policy appears to be a means for managers to show they take into account shareholders’ interests.

Rozeff (1982) and Easterbrook (1984) justify dividend policy and dividend payments as means to put pressure on managers. As managers are compelled to pay high dividends, this will increase the probability of issuing new shares in the future. Dividend policy is a means to control ‘managers’ using ‘the market’.

Within a framework of ex-post informational asymmetry, one can follow the example of Jensen’s (1986) - Free Cash-Flow Theory¹⁶ - and consider dividend payments a means of solving the agency problem which exists between shareholders and managers. Indeed, dividends are a pressure tactic which lead managers to invest only in projects with positive NPV. Dividend payments decrease the level of “free resources” which can be used by managers and increase the incentive to put funds into profitable investments. This argument is also presented by Lang and Litzenberger (1989) who point out that a dividend increase causes a stronger increase in a stock’s price for companies with free cash-flow than for firms without free cash-flow. Moreover, Black (1976) previously stated that dividend payments could be likely to reduce an over-investment problem by reducing the free cash flow problem.

All previous studies we have presented allow for a better understanding of dividend policy, but they still remain fragmented. Indeed, they do not take into account some alternative policies such as share repurchases. Moreover, theses studies are usually static (cross sectional), but political and economic cycles can have an influence on a firm’s life and especially on dividend policy. Lastly, they do not take into account corporate governance, whereas this is an essential explanation for understanding the firms in an asymmetrical framework. All these features will be covered in the following section.

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