Which of the following statements is false? Leverage can reduce the degree of ma

Question

Which of the following statements is false?
       Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress.
       When a firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight.
       According to the empire building hypothesis, high levels of free cash flow reduce agency problems.
       Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. As a result, managers may expand (or fail to shut down) unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.

Explanation / Answer

Statement (C) According to the empire building hypothesis, high levels of free cash flow reduce agency problems is FALSE: explanation as below:

Free cash flow is the excess of cash that is required to fund all positive projects. Managers have discretion to use free cash flow and this creates potential agency conflict. Managers can use free cash flow for enjoying perquisites or invest this free cash flow to increase resources under their control for empire building. This empire building would allow managers to create higher salaries and would offer greater power to them. This investment by managers creates overinvestment problem and investment in unviable projects.

This conflict created by free cash flow can be controlled by using debt in capital structure. By issuing debt, the managers of firm are obliged to make periodic payments of interests and principal. These periodic payments reduce amount of free cash flow available for use by managers and hence reduces agency conflict between owner and managers. The use of debt also increases monitoring of managers’ activities.Large debt holders also have contractual right to monitor activities of manager. This monitoring by creditors also helps owners in monitoring managers and reduces cost of monitoring managers by owners.

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