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

A company holds large surplus cash with no profitable investment opportunities. Managers propose acquiring an unrelated business that would raise the size of the group and their own prestige, though the expected NPV is negative. Which action by the board would best address the resulting agency cost?

The board should return surplus cash to shareholders through dividends or buybacks. This removes managers' discretion over free cash flow and stops empire-building into negative-NPV acquisitions, whereas retaining cash or raising equity would leave more resources under managers' control.

  1. AApprove the acquisition because larger firms are always more valuable
  2. BRetain the cash to build a bigger cash buffer for managers to use
  3. CReturn the surplus cash to shareholders through dividends or a buyback, reducing managerial discretion over free cash flowCorrect
  4. DIssue additional equity to fund the acquisition
  5. Cut the dividend to zero so more funds remain under management control

Explanation

This is the free cash flow problem: managers with surplus cash may undertake negative-NPV projects for empire building. Distributing the cash removes their discretion and returns value to shareholders. Approving the deal, retaining cash, cutting dividends or issuing equity would increase or preserve the managers' control over resources and the waste.

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