Dividend Policy and Agency Costs

The assignment analyzes the rationale behind firms offering dividends to their shareholders, focusing on their role in reducing agency costs. Specifically, it investigates how dividends can alleviate conflicts of interest that may arise between management and investors. The document draws upon academic research and real-world examples to support its arguments.

Financial Management

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................3
MAIN BODY..................................................................................................................................3
Discussing the proposition that a company's dividend policy is irrelevant to its market value. .3
CONCLUSION................................................................................................................................7
REFERENCES................................................................................................................................8

INTRODUCTION
Financial management is the process that investors and business units employ for
ensuring effective as well as efficient usage of funds. Attainment of high profit margin is one of
the main objectives of both investors and business organization. With the motive to fulfill the
expectation level of investor’s business unit offers return to the shareholders in the form of
dividend. In the context of business unit, executives and management team plays a vital role in
setting out dividend policy. Hence, in this, report will provide deeper insight about the aspects of
dividend relevancy and irrelevancy. Besides this, it also depicts the manner in which dividend
policy has influence on market value. It also sheds light on the extent to which dividend policies
employed by the firm create agency problem or issues.
MAIN BODY
Discussing the proposition that a company's dividend policy is irrelevant to its market value
In the recent times, matter pertaining to the influence of firm’s dividend policy on the
current share price level has gained high importance. Now, from corporate officials to investors
as well as economists everyone is concerned about the impact that dividend policies of the firm
have on market value.
Dividend irrelevancy
According to the views of Hamza and Hassan (2017, p1), dividend irrelevance theory
entails that investors are not concerned with the dividend policies employed by the firm.
Moreover, as per such theoretical framework, for fulfilling cash requirements investors can sell
out the part of their equity shares. MM model states that dividend policy is irrelevant in a perfect
world where no taxes and bankruptcy costs take place. However, on the critical note, Wanjohi
(2017, pp.183-205) stated that assumptions undertaken by MM are irrelevant pertaining to the
existence of perfect capital market with no tax implications. Further, such theory is also
criticized as it assumes that wealth of the shareholders not highly influences from dividends. The
rationale behind the same is transaction cost which in turn associated with the selling of shares or
cash inflows. On the basis of this MM theory of irrelevancy, Ali, Mohamad and Baharuddin

(2018) stated that dividend policy has no significant impact on the share prices and capital
structure of the firm. Moreover, MM theory presents that when investors get high dividend then
they are expected or encouraged to invest surplus cash flow in the stock of an organization.
Hence, in accordance with the dividend irrelevancy framework, under perfect market conditions,
investors do not care about return appreciation from dividend or stock price.
Dividend relevancy
Iftikhar, Raja, and Sehran (2017, pp.32-37) assessed that Gordon theory describes the
aspects of dividend relevancy in a precise and effectual manner. Such theory is also known as
‘Bird-in-the-hand’ which in turn presents that current dividend policy significantly contributes in
the determination of firm’s value. As per Gordon model, dividend paid, cost of capital and
annual growth rate of the business unit has high level of impact on the market value. However,
Gordon model is to be critically evaluated by Bahns, D. and Rejzner, K. (2018, pp.421-446) who
presented that assumption regarding the constancy of wealth of shareholders and business risk
are inaccurate. On the other side, Baker and Jabbouri (2017, pp.1332-1347) depicted that,
considering the Gordon theory of dividend relevancy, relationship that takes place between
return and cost of capital has significant impact on the market price per share of the company.
Agency problem
Harford, Wang and Zhang (2017, pp.1490-1538) described agency problem as a situation
of ‘conflict of interest’ that exists between management and shareholders of the business unit.
On the basis of such relationship, managers act as an agent of the sharer or stockholders. Hence,
shareholders expect that manager will take appropriate decision that contributes or enhances their

wealth. As per the agency relationship principal (manager) performs task on the behalf of
shareholders. Bebchuk, Cohen and Hirst (2017, pp.89-102) mentioned in their study that agency
problem arises due to the incentive issue. Moreover, agents may be motivated to perform acts in
a undesirable manner or in against to the best interest of shareholder when they provided with the
incentives for acting in a certain way. Sun, et al. (2017, pp.186-199) found that agency problem
can be reduced or eliminated through altering the structure of compensation. In addition to this,
through the means of performance feedback and independent evaluation accountability of the
agents can be ensured for suitable decision making.
Company market value
Market value of the company implies for capitalization that is determined through
multiplying outstanding shares with the current price. In other words, market capitalization refers
to the value of company’s outstanding shares. Investors lay high level of emphasis on
determining the figure of market capitalization with the motive to assess the size of business
operations. Hence, value of market cap or company is highly significant which in turn helps in
attracting more investors.
How does a dividend policy affect market value?
MM model is based on some specific assumptions such as no market imperfections, taxes
and transaction cost exists (Ani, 2018). This theoretical framework regarding dividend policy
entails that investors do not need dividend for converting their shares into cash. On the basis of
Miller and Modigliani model investors will not be ready to pay high prices for the firm having
more dividend payouts. MM model or framework states that firm has settled its investment
programme. As per MM model, any surplus from financing decision will be paid out in the form
of dividend. In the case, when firm takes decision in relation to increasing dividend without
changing the debt level then extra returns are financed through the means of equity issue. Hence,
in this, new shareholders contribute with cash in the exchange for new share issuance. Thus,
subsequently, new cash generated is paid out in the form of dividend. Referring such aspect, it
can be depicted that cash is exchanged for the payment of shares so no significant impact takes
place on the value of firm.

Iftikhar, Raja, and Sehran (2017, pp.32-37) presented dividend policy as a trade-off
between retained earnings and paying out cash. In this regard, opposing views have assessed
regarding the impact of dividend policy on firm’s value. Hence, it has found from the evaluation
that dividends are usually taxable that MM theoretical framework completely ignores. In this
regard, business units can convert their dividends into capital gain by shifting policies. Thus,
when dividends are taxed heavily as compared to capital gain then investors who pay tax prefer
such move. Meanwhile, value of the firm will increase as total cash flow retained by companies
or investors considered as higher rather than when dividend paid. Hence, when tax associated
with capital gain is lower over dividend income business units should lay focus on offering fewer
dividends.
Dividend policy – does this impact on agency – if so, how?
From assessment, it has identified that, in the modern era, agency problems arise due to
the conflicts between corporate insiders and outsiders. Dividend policy which is undertaken by
the firm has an impact on agency problem or relationship (Haye (2014). Transaction cost
associated with the dividend policy of firm sometimes creates conflicts between management
and shareholders. Moreover, for offering dividend to the shareholders company has to incur
some cost and the same is facing by the investors. Hence, conflicts occur between management
and shareholders due to the dividend policy because agency costs are considered as loss to the
investors. On the other side, Caelers (2010) suggested that dividend payments are an important
device or strategy that can be used for reducing agency cost or conflicts. In other words, when
managers set dividend payout policy the related payments assist in reducing agency cost.

Further, it has identified from the evaluation that agency approach is highly moving away from
the assumptions of MM theory or model. Firstly, firm’s investment policy cannot be separated
from its dividend policy because strategy pertaining to paying out dividends may reduce the
efficiency of marginal investment. Secondly, allocation of all the profit margins to the
shareholders cannot be taken for granted. Thus, dividend is paid on a pro-rata basis which in turn
offers benefit to the outsiders relative to retained earnings. However, Parikh (2018) presented in
their study that when dividends are paid then equity of the firm is maintained at its target level
through the issuance of additional common stock. Business units rarely sell equity shares for
offsetting dividend payment and maintaining a constant financial structure. Meanwhile, in
against to the dividend irrelevance assumption policy associated with the same influence asset
composition, capital structure, investment plans and therefore firm’s value.
CONCLUSION
By summing up this, it has been articulated that dividend policy of the firm has
significant impact on the market value of firm. It can be seen in the report that tax is one of the
main factors that have significant influence on the firm’s value. Thus, referring the trend of tax
business units should set dividend policy. Besides this, it can be inferred that the main objective
of firm behind offering dividends to the shareholders is to reduce agency cost especially the one
takes place between management and investors.

REFERENCES
Books and Journals
Ali, N. Y., Mohamad, Z. and Baharuddin, N. S. (2018). THE IMPACT OF OWNERSHIP
STRUCTURE ON DIVIDEND POLICY: EVIDENCE OF MALAYSIAN LISTED
FIRMS. Journal of Global Business and Social Entrepreneurship (GBSE), 4(10).
Bahns, D. and Rejzner, K. (2018). The Quantum Sine-Gordon Model in Perturbative
AQFT. Communications in Mathematical Physics, 357(1), pp.421-446.
Baker, H.K. and Jabbouri, I. (2017). How Moroccan institutional investors view dividend
policy. Managerial Finance, 43(12), pp.1332-1347.
Bebchuk, L. A., Cohen, A. and Hirst, S. (2017). The Agency Problems of Institutional
Investors. Journal of Economic Perspectives, 31(3), pp.89-102.
Hamza, S. M. and Hassan, Z. (2017). Impact of dividend policy on shareholders wealth: a
comparative study among dividend paying and non-paying technology based firm’s in
usa. International Journal of Information, Business and Management, 9(3), p.1.
Harford, J., Wang, C. and Zhang, K. (2017). Foreign cash: Taxes, internal capital markets, and
agency problems. The Review of Financial Studies, 30(5), pp.1490-1538.
Haye, E., (2014). Dividend Policy and Agency Effects: A Look at Financial Firms. International
Journal of Economics and Finance, 6(2).
Iftikhar, A. B., Raja, N.U.D.J. and Sehran, K. N. (2017). IMPACT OF DIVIDEND POLICY ON
STOCK PRICES OF FIRM. Theoretical & Applied Science, (3), pp.32-37.
Sun, J. et al. (2017). Principal–principal agency problems and stock price crash risk: Evidence
from the split‐share structure reform in China. Corporate Governance: An International
Review, 25(3), pp.186-199.

Wanjohi, M. M. (2017). Effects of dividend policy on shareholders wealth: Evidence from
insurance firms in the Kenya. International Academic Journal of Economics and
Finance, 2(3), pp.183-205.
Online
Ani, G. (2018). Dividend Irrelevance Theory. Online. Available through: <
http://www.dividend.com/dividend-education/dividend-irrelevance-theory/>. [Accessed on
7th March 2018].
Caelers, L. (2010). The relation between dividend policies and agency conflicts. Online.
Available through: < http://arno.uvt.nl/show.cgi?fid=107724>. [Accessed on 7th March
2018].
Parikh, C. (2018). Dividend Policy and Agency Problems. 2018. Online. Available through: <
https://capitalideasonline.com/wordpress/dividend-policy-and-agency-problems/>. [Accessed
on 7th March 2018].