Question

Uncontrolled free cash flow and agency concerns may be a sign that

a. a firm is using too much debt financing

b. a firm is using too much equity financing                                                           

c. managers own a disproportionate share of the firm

d. managers are underinvesting the firmʹs cash flow

Answer 1

Agency problem in corporates mean that there is a conflict of interest between the manager and the other share holders. The managers plays the role of an agent for the principal (shareholder). He is ideally supposed to act in the best interest of the principal but there could always be a situation where there is a conflict of interest and the manager could act in such a way that could aid his personal interests (increase in his wealth) and antagonize the shareholder's interests. This is called the agency problem.

A company with huge free cash flow is supposed to return the cash flow to the stock holders as a return. This shall increase the share prices and thereby the wealth/profit for the shareholders/stock holders. However, the manager in his personal interest could instead reinvest the free cash flow in non profitable and/or less return yielding investments and earn non-pecuniary benefits from his company and increase his wealth. By investing in less yielding asset classes, the stock prices of the company could come down and become a potential takeover target. these are the main concerns of agency problems of a company with huge free cash flow. These theories are explained in the Agency problem in management and Free cash flow theory by Jensen in 1976.  

Coming back to our question, it is understood from the above explanations that a company with uncontrollable free cash flows and agency problem is likely to be assumed that the managers could be under-investing the firm's cash flow in less profitable asset classes. Option d.

Option A and B is not correct since both debt financing and equity financing will bring so many outsiders into the decision making process and the manager's holding would be only a fraction in the company.