Question

19. Which of the following statements is FALSE? A) Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress. B) When a firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight. C) According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers. D) 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.

Answer 1

Answer: C) According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.

Step-by-step explanation:

This statement is false because it is not the definition of the Empire Building Hypothesis.

It is rather, the definition of the Free Cash Flow Hypothesis which essentially believes that a company that is making a lot of free cashflow is not as disciplined in handling money as a company that has debt obligations. It claims that when a company has a lot of free cash flow it tends to invest in bad projects.

The FREE CASH FLOW HYPOTHESIS not the Empire Building Hypothesis therefore believes that leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.