Question 9.RQ.4: Describe how agency theory may help to explain the dividend ...

Agency theory is based on the idea that the business is a coalition of interest groups, with each group seeking to maximise its own welfare. This behaviour is often at the expense of the other groups, and so ‘agency costs’ arise. In order to minimise these agency costs, the particular group bearing the costs may seek to restrain the actions of others through contractual or other arrangements. Thus, in order to prevent managers from awarding themselves various perks, the shareholders may insist that all surplus cash is returned to them in the form of a dividend.

Similarly, in order to prevent shareholders from withdrawing their investment in the business and allowing lenders to bear all, or the majority of, the risks of the business, the lenders may seek to limit the amount that can be declared in the form of a dividend.