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

Shareholders of a highly geared company may prefer a riskier project than the lenders would. Which statement correctly describes this conflict?

Shareholders in a highly geared firm keep the upside of risky projects but, through limited liability, share the downside with lenders, who earn only fixed returns. This encourages risk-shifting, which lenders counter using covenants, so the conflict does not vanish with unsecured debt.

  1. AShareholders gain from the upside of risky projects while lenders bear much of the downside, so shareholders may favour risk-shiftingCorrect
  2. BLenders gain more than shareholders from the upside of risky projects
  3. CBoth parties always prefer the lowest-risk project
  4. DThe conflict disappears when debt is unsecured
  5. Shareholders are legally prohibited from approving risky projects

Explanation

With limited liability, shareholders' loss is capped while their upside is unlimited, whereas lenders receive only fixed interest and principal but suffer if the firm fails. This encourages risk-shifting, which lenders try to curb with covenants. Unsecured status does not remove the conflict.

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