Question

What is the relationship between cash holdings and agency costs?

Answer 1

The objective of financial management is to maximize the wealth of Equity shareholders. Shareholder’s wealth is represented by the market capitalization of the company. So a finance manager is supposed to take financial decisions with a view to increase the share price of the company on a sustainable basis.
There are three major financial Decisions:
a)Financing Decision ie Procurement of Funds
b)Investment Decision ie Deployment of Funds
c)Dividend Decision ie Decision regarding payout of funds

Agency cost refers to the loss in firm value on account of conflict between the interest of:
Shareholders ( ie Principal) & management (ie Agent)

The management may want profit maximization which is more of a short term in nature which would benefit the management as their profit incentives are linked to profits. But the  shareholders , who are the real owners of the company would want to get wealth maximization which is more long term and sustainable and would raise share value.

classic Example can be seen in 2008 financial crisis where Nine of the financial firms that were among the largest recipients of federal bailout money paid about 5,000 of their traders and bankers & executives bonuses of more than Rs.1 million apiece for 2008. This truely depicts the agency cost and principal-agent conflict.

Excess cash holdings provide liquidity to the organization and the Agents , ie the Management may be lured to misuse the cash holding for personal benefits which would be detrimental to the interest of the shareholders.