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

We can agree to this statement. Agency problem arises when the managers act on behalf of their interest rather on shareholders.

In the firms that rely on their internal source of funds that is retained earnings to finance investment opportunities there will be a greater agency problem. Because, the earnings of the company is utilizing for investment rather distributing it to the shareholders. The investments are done by the managers. Then there is a chance that they give priority to their interests than that of shareholders.

But in the case of companies, which use external capital for financing, there is less chance for agency problem. Because the earnings are not used for investing in the company. The earnings are distributed to the shareholders as dividends. Then there will not be much free cash flow for the managers to use it for their interests. Thus there will not be agency problem related to this factor.

jeff jeffy answered 2 years ago

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