Question

3 marks] Explain how debt reduces the agency costs of free cash flows [answer in no more than 100 words]

Answer 1

One of the root cause of the agency problem between managers and shareholders is the availability of excess cash than required. Managers would like to invest the Cash flow in the new projects which may have lesser return, and it will reduce the overall return of shareholders. Shareholders will prefer distribution of cash. If not, the share price will fall firm may become target of hostile takeover. But if the firm has debt financing, the cash has to be paid for payment of interest or repayment of principal, thereby reducing the chances of agency problem or agency cost.