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ACCA Applied Skills · Financial Management · The nature and purpose of financial management

A highly geared company is considering a very risky project with a small chance of a large return. Equity holders would gain from success, while lenders would bear much of the loss on failure. Which conflict does this illustrate, and which control would best protect lenders?

This is a conflict between shareholders and lenders, because shareholders gain from upside while lenders bear downside risk. Lenders protect themselves with restrictive covenants in the loan agreement, limiting further debt, dividends or risky asset changes.

  1. AConflict between managers and employees; a profit-sharing scheme
  2. BConflict between shareholders and lenders; restrictive covenants in the loan agreementCorrect
  3. CConflict between shareholders and customers; a lower selling price
  4. DConflict between managers and government; increased tax planning

Explanation

Shareholders in a highly geared company have limited liability and can benefit from upside, so they may favour high-risk projects that transfer risk to lenders. Lenders respond with covenants that restrict further borrowing, dividends or asset disposals and may require security. The other pairings do not match the described conflict.

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