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IAI Actuarial Core Principles · Business Finance · Corporate governance and the regulation of companies

A company has surplus cash of Rs 500 crore and no projects with a return above its cost of capital. Management proposes to acquire an unrelated business, which would increase the size of the firm and its executives' pay. Which analysis is most accurate?

This is empire building: managers gain size and pay from an unrelated acquisition while shareholders get no excess return. With no project beating the cost of capital, returning cash by dividends or buybacks better serves shareholders. Larger size does not automatically create value, and law does not require acquisitions.

  1. AThis is acceptable because larger firms always create more shareholder value
  2. BThis suggests empire building, and returning the cash through dividends or buybacks would better serve shareholdersCorrect
  3. CThis is a conflict only between lenders and auditors
  4. DThe acquisition is required by company law whenever cash is surplus
  5. It reduces agency costs because managers' pay rises

Explanation

With no projects earning above the cost of capital, retaining cash for an unrelated acquisition is typical empire building, where managers benefit from size and pay. Distributing the cash lets shareholders reinvest at their required return. Higher pay for size does not align interests; it is a symptom of the conflict.

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