An Investigation of the Dynamic Relationship between Agency Theory and Dividend Policy

Abstract Agency theory posits that the dividend mechanism provides an incentive for managers to reduce the costs associated with the principal/agent relationship. Distributing resources in the form of cash dividends forces managers to seek outside capital, thus causing them to reduce agency costs as they subject themselves to the scrutiny of the capital marketplace. Under this scenario the optimum level of dividend payout is that which minimizes the agency cost structure relative to the cost of raising needed funds. A test of this theory employing time‐series cross‐sectional analysis and more direct measures of the agency cost structure shows that these tenets of agency theory may be valid. Managers do appear to adjust the dividend payout in response to the agency cost/transaction cost structure, both through time as well as across firms.