Question

Lincoln Corporation has accumulated a large amount of cash flow. The CEO proposes to fly all managers to a luxury resort in Hawaii at the end of the year for a one-week holiday using the corporate jet. Describe how the company’s capital structure could be changed to prevent managers from spending the company’s cash on the luxury holiday, but instead investing the cash in positive NPV projects. Explain why the proposed change to capital structure could help encourage investment in positive NPV projects.                                                                    

Answer 1

There should be always a focus on investment into those products which will be yielding positive net present value to the company because these project will lead into value maximization and addition of overall profit to the company.

Spending on luxury to all managers is against the policy of the sound management and protection of the interest of the stakeholders because cash flow which have been accumulated is part of the shareholders equity, and they are belonging to the shareholders of the company and cannot be spent on the luxury of the managers, so these cash flows are to be stored in order to have a better liquidity for the company.

When the company will have an optimum amount of cash flow, it will mean that the company will have the liberty of acceptance of various projects as and when it wants. Optimum amount of cash flow will also have the company a better credit rating and a better standing chance against its competitors for debt repayment and growth and expansion so these cash flows can be invested into all such projects which will be maximizing the overall value of the company and which will be helpful in providing it with a competitive moat through debt financing.

So change in the capital structure of the company would be to adopt a large amount of DEBT CAPITAL because it will lead to regular payments of debt and help in expansion of the company and those cash will be eused to set off the interest expenses and it can help the company to grow faster.