An Agency-Cost Model of Dividends, Repurchases and New Equity Issues

This paper develops an agency-cost model of firm financial policies, building on the intuition in Easterbrook (1984) and Jensen (1986). Agency costs arise when managers gain by investing available cash even when doing so lowers share values. Dividends then restrict the cash available to managers. While there is empirical evidence linking free cash flow and dividends, a formal model is missing. We show that an agency-cost model can explain not only the use of dividends but also a long list of other stylized facts about firm financial policy. Even under the most optimistic assumptions, however, capital investment remains inefficient, and is sensitive to free cash flow