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

A highly geared Indian manufacturer has a project choice. Project A is safe with modest returns. Project B is very risky with a small chance of a large payoff. Shareholders, who have limited liability, favour B even though B has a lower expected net present value than A. Which conflict does this illustrate?

This shows a shareholder-lender conflict, often called risk shifting or asset substitution. Under limited liability and high gearing, shareholders keep the upside of a risky project while lenders bear much of the downside, so shareholders may favour it even with lower expected NPV.

  1. AConflict between shareholders and lenders, through asset substitution or risk shiftingCorrect
  2. BConflict between managers and employees over redundancy
  3. CConflict between the company and its customers over pricing
  4. DConflict between majority and minority shareholders over dividends
  5. Conflict between auditors and regulators over disclosure

Explanation

With high gearing and limited liability, shareholders gain most of the upside of a risky project while lenders bear much of the downside. Choosing B despite its lower NPV transfers value from lenders to shareholders. This is the risk-shifting problem, which lenders limit through covenants and security.

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