5. Agency Costs

We have also argued that investors might be concerned that managers waste excess cash on NPV-negative projects. 

To "prove" to the market that they will not fall pray to this so-called free cash flow problem, managers could self-impose a payout policy that will strip the firm of its future excess cash and return it to shareholders.

As we have discussed at various instances already, dividends represent a stronger commitment to future payouts than buybacks, which is why dividend payments could send a more credible signal to the market.

In fact, the argument goes beyond the use of excess cash. As we discuss in the module Capital Structure Decisions, proponents of debt financing argue that debt could have the same positive effect, as it puts pressure on the management to work hard in order to be able to repay the future debt obligation.