IAI Actuarial Core Principles · Business Finance · Ethical responsibilities of owners and managers
A company has surplus cash and no profitable projects. The CEO, whose status depends on firm size, plans to acquire a loosely related business at a large premium, although shareholders would prefer a special dividend. Which concept does this best illustrate, and which remedy is most directly aimed at it?
This is empire building driven by free cash flow: managers expand the firm for status rather than value. Remedies include returning surplus cash through special dividends or share buybacks, using debt to impose discipline, and strengthening independent board oversight of acquisitions.
- AMoral hazard by lenders; remedy is lower gearing
- BEmpire building through free cash flow; remedy is returning cash via dividends or buybacks and stronger board oversightCorrect
- CInformation asymmetry between customers and the firm; remedy is advertising
- DAdverse selection in the labour market; remedy is higher wages
- Short-termism by shareholders; remedy is longer lock-in periods for employees
Explanation
Managers with excess free cash may invest in value-destroying growth to enlarge the firm they control, known as empire building. Paying out surplus cash as dividends or buybacks, or using debt to impose discipline, and having independent board oversight, reduces the problem. The other options mismatch the concept or the remedy.
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