ACCA Strategic Professional · Advanced Financial Management · The role and responsibility of senior financial executive/advisor
Which governance mechanism most directly reduces the agency cost arising from managers' tendency to retain surplus cash rather than distribute it to shareholders?
Increasing gearing most directly curbs the retention of surplus cash, because fixed interest and repayment obligations take cash out of managers' discretionary control. This reduces empire building and value-destroying investment, lowering agency costs from free cash flow.
- AIncreasing the level of gearing, since mandatory interest and principal payments reduce free cash under managerial controlCorrect
- BIssuing more ordinary shares to fund investment
- CAwarding managers a fixed salary with no performance element
- DReducing the number of non-executive directors
Explanation
Jensen's free cash flow argument holds that debt commits cash to lenders, limiting discretionary spending on low-return projects or empire building. Issuing shares or fixing salaries does nothing to constrain cash use, and fewer non-executives weakens monitoring.
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