How More Reduce Lower Agency Cost

1. How High Dividend Payouts Reduce agency cost /consider out dividend??
1. Introduction
Agency cost is an internal cost which arises between management (agent) and shareholder
(principal), because of the diverging interest of the two parties. Dividend payments are often
employed to mitigate this cost. Studies have examined the effect of dividend payouts on agency
costs documenting mixed findings. Since Jenson and Meckling (1976), many studies
have provided arguments that link agency costs with the other financial activities of a firm. It
has been argued that firms payout dividends in order to reduce agency costs. Dividend
payout keeps firms in the capital market, where monitoring of managers is available at
lower cost. If a firm has free cash flows (Jensen (1986), it is better off sharing them
with stockholders as dividend payout in order to reduce the possibility of these funds
being wasted on unprofitable (negative net present value) projects. This modern view of
dividend policy emphasizes the valuable role of dividend policy in helping to resolve
agency problem and thus in enhancing shareholder value. Therefore, the purpose of this desk
review is to understand How High Dividend Payouts Reduce agency costs based on the agency
theory of dividend policy (main source).
2. The Relationship
There is a lot of literature which deals with dividend policies of firms. Much of this review is
based on the explanation for the dividend puzzle which is that dividend policies address agency
conflicts between corporate insiders and outside shareholders (Porta et al, 2000).
Agency conflicts arise when there is an agency relationship between certain people.
Jensen and Meckling (1976) define this relationship as a contract under which one or
more persons (the principal(s)) engage another person (the agent) to perform some service on
their behalf which involves delegating some decision making authority to the agent. Here
an agency conflict is defined as a conflict of interest between corporate insiders (the
agents) and outside shareholders (the principals) (Porta et al, 2000), or in other words
between managers and shareholders. There is good reason to believe that the manager
will not always act in the best interest of the shareholder (Jensen and Meckling, 1976).The

2. main cause of this conflict of interest is the separation of ownership and control between
shareholders and managers (Manos, 2001). As suggested by Jensen and Meckling (1976),
managers of a publicly held firm may allocate resources to activities that benefit them, but that
are not in the shareholders' best interest. These activities can range from lavish expenses on
corporate jets to unjustifiable acquisitions and expansions. In other words, too much cash in
the firm may result in overinvestment.
The discuss on the agency conflicts, automatically involve agency costs. Agency costs are
defined as the loss to shareholders of controlling agency behavior, through measures taken by
themselves and by managers as well as the costs from any agency behavior that has not
been controlled (Manos, 2001). Shareholders can limit divergences from his interest, which
arise when managers act in their own interest, by establishing appropriate incentives for
the managers incurring monitoring costs designed to reduce the aberrant activities (Jensen
and Meckling, 1976). It is also possible that the shareholder will be compensated by the
manager when the manager takes actions that harm the shareholder (bonding costs). In most
agency relationships the manager and shareholder incur positive monitoring and bonding costs
and there will be some divergence between the interest of the manager and the shareholder. This
brings us to a third part of the total agency costs, the residual loss. This loss is the dollar
equivalent of the reduction in welfare caused by the divergence in interests and which is
experienced by the shareholders (Jensen and Meckling, 1976). In short, agency costs are the sum
of the monitoring expenditures by the shareholders, the bonding expenditures by the
managers and residual loss (Jensen and Meckling, 1976).
Many researchers have concluded in their papers that dividend payments are an important
device in reducing agency conflicts and therefore agency costs. Even if it is the manager
who determines the dividend payout policy, the dividend payments are an important device in
mitigating agency costs. When, for example, managers use the firm’s resources for consumption
that is in their own interest instead of in the interest of the shareholders, these managers
enjoy the total benefit from this consumption, but the managers only have to deal with a part
of the costs of the wasted resources. The remaining costs are for the shareholders. Despite
managers only having to deal with a part of the total costs, the managers may also suffer from
such self-interested behavior (Manos, 2001).The managers of a firm which will retire within a

3. certain amount of time or stop working for the firm within a couple of years, are only concerned
in the short term instead of in the long term. Because most of the negative effects that are
associated with agency problems will raise in the long term, these managers will act in a self-
interested way, because they wouldn’t have to deal with these negative effects like losing their
position through a hostile take-over. If the market suspects managers are inefficient, it is also
possible that share price may decline, which has an effect on the managers’ salary,
reputation and career opportunities. While the managers which cause these negative effects
already have left the firm, the other managers will suffer from this self-interested behavior.
Because of these negative effects of the agency problems for managers which will stay within
the firm, managers will also take measures, in addition to those taken by shareholders, to reduce
the potential for agency conflicts (Manos, 2001). It is the group of managers who do not behave
self-interested that will take those measures to reduce the potential for agency conflicts caused
by the group of managers who does act in a self-interested way. Long et al. (1994) also conclude
that most of the managers are concerned about their reputation. Often reputation has greater
value to the firm and its management than the value of the benefits to be obtained by a
one off wealth expropriation. If reputation is important to managers and acting as
predicted by agency theory can harm their reputation, then it may be in the managers’ interests to
show that the firm is free of potential agency problems. One way for managers to create
reputation, particularly in countries with poor protection for minority shareholders, is by paying
dividends which signals decent treatment of minority shareholders (Manos 2001; Long et al,
1994). This idea is developed in La Porta et al. (2000) who term it the substitute model of
dividends. Whether the motivation to pay dividends is due to the need by insiders to
create reputation for good treatment of minority shareholders, or is the outcome of pressure
by minority shareholders, dividends derive their value from reducing agency problems.
Another possible way to mitigate agency conflicts comes from Easterbook (1984). When a firm
has not enough internal resources to finance their dividend payouts, it must borrow money which
will lead to the raising of external finance. This external finance leads to investigation of the firm
by financial intermediaries such as investment banks, regulators of the securities exchange where
the firm’s stock is traded and potential investors. This capital market monitoring reduces agency
costs and lead to appreciation in the market value of the firm (Easterbook, 1984).

4. Another solution to the agency conflict is stated by Jensen (1986). If the cash that
management controls can be minimized, it is harder for management to (unmonitored)
spend this money on activities which are in their own interest. The less discretionary cash
management has, the harder it is for them to invest in negative NPV projects. One way to take
unnecessary cash from the firm is to increase the level of dividend payouts (Allen and Michaely,
1995).
In response to the above one can raise the question: if there is no excess cash available anymore,
why not borrow money to make these negative investments or use the cash available for
these negative NPV investments and borrow money to pay the dividends? The answer to the
first part of the question is that when managers borrow money to make negative
investments, high costs will arise for those managers which are acting in a self-interested
way. For this group it is costly to borrow money to invest in negative NPV, because then they are
monitored by external parties and these parties will find out about the self-interested behavior.
Even if the managers will use the borrowed money to invest in negative NPV projects, external
parties will find out about this soon and this may damage the reputation of the managers
and as said before, reputation is very important for managers (Long et al, 1994). It is the group
that acts in a self-interested way that doesn’t want to get caught by external parties so they
do not want to borrow money. The answer to the second part of the question is the same
as for the first part which stated that more borrowing leads to more external monitoring, but also
comes from the study of Long et al. (1994). Long et al. (1994) have investigated the
validity of the agency cost of debt.
3. Conclusion
Prior literature argues that firms use their policy of dividends to mitigate existing agency
conflicts. Rozeff (1982), Moh’d et al. (1995) Porta et al. (2000) and Lozano et al. (2005)
are a couple of researchers who think that the dividend policy is a useful tool to reduce
agency conflicts and so agency costs. Besides the dividend payout mechanism, this study has
also paid some attention to a second group of mechanisms for mitigating agency problems
between managers and shareholders, namely the remaining agency controls. Henry (2010)
and Kose and Anzhela (2006) stated that corporate governance is a useful device to reduce

5. agency conflicts, while Bathala et al, (1995)are one group of researchers who believe that insider
ownership and ownership concentration is a useful device.
The dividend policy of individual firms is continually a subject of economic interest. But
why is dividend policy so interesting? Allen and Michaely (1995) give several reasons. One
reason is that deciding on the amount of earnings to pay out as dividends is one of the major
financial decisions that firm managers face. Another is that a proper understanding of dividend
policy is crucial for many other areas of financial economics. In particular, theories of asset
pricing, capital structure, mergers and acquisitions, and capital budgeting all rely on a view
of how and why dividends are paid (Allen and Michaely, 1995). Another couple who
believes dividend policies are a very interesting topic is Modigliani and Miller (1961). This
couple came with the dividend irrelevancy theory and it states that, in a frictionless world,
when the investment policy of a firm is held constant, there are no consequences for
shareholder wealth by the kind of dividend policy. Despite this irrelevancy, there are many
differences in dividend policies used by firms, what makes dividend policies also very
interesting.
Often the concept of the dividend policy of a firm is not standing alone when we talk
about this economic subject, but usually is associated with various other topics which are
of economic importance. Hence, the possible ways to mitigate the agency conflicts and which
includes the dividend policy mechanism comes from Easterbook (1984) and Jensen (1986).
With reference to the different earlier studies, I would like to conclude that the relationship
between the dividend policy of a firm and agency conflicts is negative. Which is to mean that,
the more the dividend Payouts existed the more will be reducing agency costs.