In a well done and interesting work, DeAngelo, DeAngelo, and Stulz tie dividend policy and agency costs (particularly the free cash flow problem) together. Their main point is that if firms did not pay dividends, managers would have too much cash at their disposal.
The authors begin by asking the question “why do firms pay dividends.” To answer the question they examine what would happen if firms didn’t pay dividends. Specifically they “conservatively estimate that, had the 25 largest long-standing dividend-paying industrial firms in 2002 not paid dividends, they would have cash holdings of $1.8 trillion (51% of total assets), up from $160 billion (6% of assets), and $1.2 trillion in excess of their collective $600 billion in long term debt. Absent dividends , these firms would have huge cash balances and little or no leverage, vastly increasing managers’ opportunities to adopt policies that benefit themselves at stockholders’ expense.”
Moreover, the paper makes the important distinction (made before by Jensen & Meckling 1976 and Easterbrook 1984) that earned equity is in someways different than contributed equity (external financing). [FinanceProfessor.com Annotation]
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