ACCA Applied Skills · Financial Management · Financial objectives and relationship with corporate strategy
Shareholders of Orion Co hold a diversified portfolio. Managers, whose wealth is tied to Orion alone, reject a positive-NPV project because it has high risk specific to Orion. Which statement best explains this behaviour?
Managers whose careers and wealth depend on Orion fear firm-specific risk that diversified shareholders can eliminate. Their risk aversion makes them reject a positive-NPV project, so their goals diverge from shareholders' and shareholder wealth is reduced.
- AManagers are risk-averse about firm-specific risk that shareholders can diversify away, so their goals diverge from shareholders'Correct
- BManagers correctly apply the rule that all positive-NPV projects should be rejected if risky
- CShareholders require managers to avoid all projects with systematic risk
- DThe project must have a negative NPV when discounted at the managers' personal rate
Explanation
Diversified shareholders care mainly about systematic risk, while managers dependent on one firm bear its specific risk and so avoid it. Rejecting a positive-NPV project destroys shareholder wealth, an agency cost. The NPV is stated as positive, so the other options fail.
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