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

A highly geared company is facing financial distress. Its managers, acting solely for shareholders, consider replacing a safe project with a much riskier one that has a lower expected NPV but a small chance of a very large payoff. Which conflict does this illustrate?

This is risk shifting between shareholders and debtholders. Because of limited liability, shareholders keep the upside of a risky project while lenders bear much of the downside, so shareholder-driven managers may accept it despite a lower expected NPV.

  1. AShareholders benefiting from upside while lenders bear much of the downside, known as risk shifting between shareholders and debtholdersCorrect
  2. BA conflict between shareholders and employees over wage rates
  3. CA conflict between managers and auditors over fees
  4. DDividend signalling to the market
  5. A conflict between customers and suppliers over credit terms

Explanation

With limited liability and high gearing, shareholders gain from the upside of risky projects while lenders bear most of the losses if it fails. This shifts risk from shareholders to debtholders even at negative expected NPV. The other options describe different relationships.

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