Chartered Financial Analyst Level 2
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- A highly profitable company with excess cash has slowing sales growth due to a lack of investment opportunities. The best way for management to reduce agency costs is to:
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A
increase the dividend.
B
eliminate the dividend.
C
maintain the dividend at its current level.
Explanation:
Explanation
When a company has excess cash and limited investment opportunities, agency costs arise because management may be tempted to invest in negative NPV projects or engage in wasteful spending rather than returning cash to shareholders.
Key points:
- Increasing dividends returns excess cash to shareholders, reducing the cash available for management to potentially misuse
- Eliminating dividends would retain even more cash, potentially increasing agency costs
- Maintaining current dividends doesn't address the excess cash problem
This aligns with the free cash flow hypothesis - returning excess cash to shareholders reduces agency conflicts between management and shareholders.
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