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IAI Actuarial Core Principles · Business Finance · Key principles of finance

A company has substantial surplus cash but its management undertakes a large acquisition with a negative net present value, mainly to enlarge the empire it controls. Which corporate-finance idea does this most directly illustrate?

This illustrates the free cash flow agency problem: managers with surplus cash invest in negative NPV projects to build empires rather than return cash to shareholders, destroying shareholder value.

  1. AFree cash flow problem arising from agency conflict between managers and shareholdersCorrect
  2. BModigliani-Miller irrelevance of capital structure
  3. CEfficient market hypothesis in its strong form
  4. DPecking order theory of financing
  5. Time value of money

Explanation

Where managers hold surplus cash they may invest it in value-destroying projects for personal benefit such as size or prestige instead of returning it to shareholders. This is the free cash flow agency problem. Increased debt or dividends are common remedies.

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