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IAI Actuarial Core Principles · Business Finance · Key principles of finance

Shareholders of a highly geared company are considering the conflict with its lenders. Which of the following actions by management, benefiting shareholders at lenders' expense, is the classic example of that conflict?

Switching to a riskier project at the same expected NPV without telling lenders is the classic shareholder-lender conflict, because shareholders keep the upside while limited liability pushes much of the downside onto lenders.

  1. AReplacing a low-risk project with a much riskier project having the same expected NPV, without telling lendersCorrect
  2. BIssuing new equity to repay part of the debt
  3. CReducing dividends to build up cash reserves
  4. DHedging the company's foreign exchange exposure
  5. Agreeing to restrictive covenants in the loan agreement

Explanation

Shareholders have limited liability, so with high gearing they gain from upside of risky projects while lenders bear much of the downside; this is asset substitution. Equity issues, retained cash, hedging and covenants all protect or help lenders rather than transfer value from them.

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