Chartered Financial Analyst Level 2

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.