The rise of cash holdings, seemingly a global issue, has become a burgeoning issue in corporate finance research. Many believe that having too much cash may cause an agency problem that concerns many investors. Evaluate the above argument and address the following points:

a) Discuss the agency conflict between shareholders and managers.

b) Explain how excess cash might cause or worsen the agency problem.

c) What effective corporate governance mechanism/practice is recommended to alleviate these concerns?

a. Agency conflicts between managers and shareholders:

Within the context of holding too much cash in hand, a business might involve the agency conflicts between shareholders and the managers in following concerns:

Cash is the most liquid asset, which will not generate any return or additional value to shareholder's wealth in the future. In business, cash will secure the liquidity, and be a means to invest in other profitable projects. Hence, maintaining a significant balance of cash will reduce the potential increase in business valuation, which is against the shareholder's interests. From the manager's perspective, a high balance of cash will protect the firm's liquidity and always be available to invest in other projects in the future.

The significant level of cash in a business will raise a concern about the effectiveness of using money. Shareholders tend to receive the excess of cash in dividends, rather than allowing the managers to spend it ineffectively, which might cost shareholder's wealth.

b.

As mentioned in part a, shareholder would prefer to having the excess cash in their hand, rather than leaving it in the business operation for being not invested. This would raise the concern of trust between shareholders and mangers. That makes the agency issue between two groups worse if dividend is not paid out or excess cash is not invested to acquire more values to the existing business.

c. Solution to reduce the conflicts between managers and shareholders:

In this case, the financial incentive is the core concern that raises the conflicts between two groups. Excess cash would maintain operational liquidity from manager's perspective while shareholders would prefer to capture that available fund for their own investment. Usually, if this scenario occurs, the firm would pay out a portion of this cash as dividends to shareholders and maintain the rest of it for upcoming investments that promise to maximize shareholder's wealth in the future. If there is a significant excess cash and firm does not reserve any profitable projects in the future, the entire excess amount should be delivered to business owners.