Question

In your own word, Explain how excess cash might cause or worsen the agency problem.

Answer 1

Excess cash can worsen the agency problem. Firstly whenever there is excess cash, the shareholders would want it to be paid out whereas the managers would want to reinvest it in profitable ventures. Moreover as excess cash is retained, the decreasing marginal utility of funds will cause the returns and stock prices to decline. This makes the firm a lucrative takeover target which the shareholders would not want. Hence holding excess cash worsens the agency problem.