A Critique of the Logic of the Agency Costs Theory for Dividends in the Finance Literature

Abstract

This paper argues that the logic of the agency costs theory for dividends is internally inconsistent in the finance literature. Under the core assumption of the theory, that managers pursue their interests when they can, managers will not payout dividends to cut down the free cash flows that they can use for their benefits. In addition, we argue that shareholders have little direct or indirect power to force managers to payout dividends. Finance literature reports some mechanisms, mainly market forces, to make managers consider shareholders interests. However, we argue that if these mechanisms work, agency problems become insignificant and the shareholders do not need to rely on the costly dividends to reduce the free cash problems. If these mechanisms do not work perfectly, agency costs problems still exist although to a lesser extent, then managers will not pay out dividends under the core assumption of the theory.