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Firms that rely on their internal source of funds to finance investment opportunities have the potential...

Firms that rely on their internal source of funds to finance investment opportunities have the potential for a greater agency problem than firms that rely on the external capital markets for their source of funds. Do you agree or disagree? Explain

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Expert Solution

Agency problem means there is conflict of interest between company’s management and company’s stakeholders. Company’s management is supposed to act and take decisions of company on behalf of shareholders to maximise shareholder’s wealth. Management acts as an agent for the shareholders. Agency problem arises when management don’t fully act in the best interest of shareholders.

When firm relies on external capital markets, there is transfer of ownership and control of the firm to creditors in case when firm is unable to recover form debts. Agency problem is reduced when bank debt and leverage is introduced as funds to finance investment opportunities. When external capital markets are used as source of funds, there is threat to management to lose their jobs and perquisites. This makes managers to focus on maximising shareholders wealth. So to reduce agency problem firm needs to introduce external source of finance.

Therefore I agree that firms that rely on their internal source of funds to finance investment opportunities have the potential for a greater agency problem than firms that rely on the external capital markets for their source of funds.

jeff jeffy answered 2 years ago
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