This paper investigates the effect of corporate governance on the dividend policy of Korean firms when they face both agency problems and external financing constraints due to asymmetric information between corporate insiders and outside shareholders. A firm's dividend can function as an outlet of cash flow to shareholders; dividend can, therefore, deter managers' expropriation, by which dividend can decrease a firm's agency problems (Easterbrook, 1984; Jensen, 1986). Also, dividend can force managers to resort to external financing in future investment projects. If the primary capital market is under-developed or experiences severe information asymmetry, dividend can increase the firm's cost of external financing (Rozeff, 1982)). In such case, the firm has to decide its payout policy by considering both agency costs and external financing costs of dividends. Previous literature has mostly focused on the direct relationship between agency costs and dividend payments without explicitly considering external financing constraints. Therefore, a study on a firm's corporate governance and dividend policy should take into account both agency problems of dividends and firms' external financing constraints. Extant literature argues that efficient corporate governance systems including monitoring management and shareholder protection can reduce the chance of managers facing agency problems (La Porta et al., 2000 and Jiraporn-Ning, 2006 etc.). La Porta et al. (2000) empirically tested two hypotheses, an outcome hypothesis and a substitution hypothesis. The outcome hypothesis is that better corporate governance pays more dividends to decrease managers' expropriation. On the other hand, the substitution hypothesis posits that a company with weaker legal protections of minority shareholders pays more dividends to establish its reputation and compensate minority shareholders. Their results, supporting the outcome hypothesis, show that a country with better corporate governance pays more dividends. Jiraporn-Ning (2006) examined the relation between dividends and the strength of shareholder rights. Their results reveal a negative correlation between dividend payouts and shareholder rights, showing another case of the substitution hypothesis (La Porta et al., 2000). These two studies, however, do not explicitly consider the role of external financing costs with respect to the relationship between corporate governance and dividend payouts. Therefore, this paper is to provide companies with suggestions based on which they should determine their payout policies. Dividend payouts result in two counteracting effects; reducing agency problems by decreasing managers' expropriation while raising expected external financing costs. Therefore, the company should consider these two aspects when deciding its optimal payout policy. For example, a company with higher external financing costs may not want to pay higher dividends to reduce its agency problems, especially when it has a sound corporate governance system. By considering external financing constraint explicitly in corporate dividend decision, this paper overcomes the limits and ambiguity in existing empirical papers that have focused on the simple relationship between corporate governance and dividend payments. We empirically test whether an improvement in corporate governance would lead to higher dividend payments to minimize agency problems (outcome hypothesis), or alternatively whether it would lead to lower dividend payments to avoid costly external financing (substitute hypothesis). Our prediction is that the results depend on the relative sizes of agency problems and external financing constraints. We find that firms with higher external financing constraints tend to decrease dividends with an improvement in their corporate governance, while firms with lower external financing constraints tend to increase dividends with an improvement in their corporate governance. The results are consistent with our hypothesis that external financing costs affect corporate dividend decisions and that firms minimize capital costs by reducing dividend payouts with improved corporate governance. The results remain robust when we control for other firm characteristics such as growth opportunities. The empirical results show that Korean firms seem to be properly taking into consideration of agency problems, external financing constraints, and growth opportunities in their decision when making their dividend policies.
