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IAI Actuarial Core Principles · Business Finance · Ethical responsibilities of owners and managers

A company with surplus cash and no profitable projects is run by managers who are reluctant to pay it out. Which argument best explains why increasing debt financing can reduce this agency cost of free cash flow?

Higher debt commits the company to fixed interest and repayment obligations, which absorbs surplus cash and so limits managers' ability to waste it on low-return projects or perks, while the threat of default adds further discipline on their behaviour.

  1. AInterest is a fixed commitment that drains cash, leaving less available for wasteful investment and disciplining managersCorrect
  2. BDebt removes the need for any financial reporting
  3. CDebt always lowers the cost of equity to zero
  4. DDebt gives managers voting control over shareholders
  5. Debt payments are optional if cash is short, so managers keep full discretion

Explanation

Contractual interest and principal payments commit cash flows, so managers cannot spend surplus on low-return projects or perks. Failure to pay risks default and loss of control, which disciplines them. Debt payments are not optional, and debt does not remove reporting duties or lower equity cost to zero.

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