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I recently attempted the following question:
Which of the following actions is LEAST likely to increase shareholder wealth?
A. The weighted average cost of capital is decreased by a recent financing decision
B. The financial rewards of directors are linked to increasing earnings per share
C. The board of directors decides to invest in a project with a positive NPV
D. The annual report declares full compliance with the corporate governance code
The correct answer was apparently B and I don’t understand why. I know that increased earnings per share don’t automatically correlate to increased shareholder wealth but why would it be the LEAST likely option when an increase in earnings is still positive for the company? Is there a reason why Option D is not the correct answer?
The reason is that linking the rewards of directors to increases in earnings per share can encourage them to manipulate the accounts so as to ‘artificially’ show an increase in earnings.
As far as the corporate governance code is concerned, its purpose is “to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company”.