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

A highly geared company has shareholders who prefer a very risky project with a small chance of large returns, while bondholders object. This conflict is best described as:

This is asset substitution, a conflict between shareholders and debt holders. Limited liability lets shareholders keep the upside of risky projects while lenders bear much of the downside, so highly geared firms may take more risk than bondholders would accept.

  1. AAsset substitution, a conflict between shareholders and debt holdersCorrect
  2. BEmpire building by management using free cash flow
  3. CA takeover premium dispute between bidder and target
  4. DWindow dressing of the balance sheet by auditors
  5. Insider trading by directors

Explanation

Shareholders have limited liability and gain from upside while debt holders bear downside risk, so shareholders may favour riskier projects than the lenders would accept. This is asset substitution (risk shifting). The other options describe different issues unrelated to risk transfer to lenders.

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