Chartered Financial Analyst Level 2
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- Which of the following would best constrain management's ability to overinvest by taking on negative NPV projects?
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A
Increase stock dividends
B
Increase internally financed cash dividends
C
Set minimum levels of EBITDA coverage of interest charges as a condition for paying dividends
Explanation:
Explanation
Increasing internally financed cash dividends is the most effective way to constrain management's ability to overinvest in negative NPV projects because:
- Cash dividends directly reduce the cash available to management for investment
- Internally financed means using retained earnings rather than external financing
- This forces management to be more disciplined about capital allocation decisions
Other options:
- Stock dividends don't reduce cash available to management
- EBITDA coverage requirements relate to debt capacity, not directly constraining investment decisions
This approach aligns with the free cash flow theory where returning cash to shareholders reduces agency costs.
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