Skip to content

CFA Level I Exam · Investors and Other Stakeholders

Principal-Agent Conflicts and Stakeholder Conflicts for CFA Level I

Updated 7 October 2026 · Fact-checked

A principal-agent conflict arises when someone who acts for another (the agent) has interests that differ from the owner's (the principal). In corporate finance, the main cases are managers vs shareholders, shareholders vs creditors, and conflicts between share classes. You solve questions by naming the two parties, the diverging interest, and the matching control.

Understand Principal-Agent Conflicts and Stakeholder Conflicts

An agency relationship exists when one party, the agent, acts on behalf of another, the principal. In a corporation, shareholders are principals and managers are their agents. Shareholders own the firm but cannot run it day to day, so they hire managers and a board.

The problem is that agents have their own goals. Managers may prefer pay, perks, job security, empire building and low effort. Shareholders want the value of the firm's equity to rise. The gap between these goals is the principal-agent problem. It is made worse by asymmetric information: managers know more about the firm than owners do.

The cost of this gap is called agency costs. They include monitoring costs (audits, board oversight, reporting), bonding costs (the agent commits to act properly, such as contract terms or clawbacks) and the residual loss (value still lost even after monitoring and bonding). Examples: a manager buys a luxury jet, or turns down a profitable but risky project to protect their job.

Other conflicts exist too. Shareholders vs creditors: shareholders gain from upside but have limited liability, so they may favour risky projects, higher dividends or more debt. These actions can transfer wealth from creditors. Creditors' upside is capped at interest plus principal, and they bear the loss if the firm's value falls below the amount of debt, although they rank ahead of shareholders. Shareholders vs shareholders: controlling shareholders, or holders of shares with superior voting rights, may extract private benefits at the expense of minority holders. There can also be conflicts between a majority owner and minorities in a family-controlled firm.

Mitigation works by aligning interests or by raising oversight. For managers: equity-based pay, an independent board, audits, shareholder voting rights and the threat of takeover. For creditors: covenants, security over assets, seniority, and credit monitoring. For minority holders: equal-treatment rules, independent directors, disclosure, and the right to vote on related-party deals.

Key formulas to remember

Agency costs
Agency costs = monitoring costs + bonding costs + residual loss
Three components. Residual loss is what remains after monitoring and bonding.
Principal-agent link
Principal (owner) → hires → Agent (acts for principal)
Shareholders are principals and managers are agents. Boards are the shareholders' monitors.
Shareholder-creditor conflict
Shareholders: upside unlimited, downside limited. Creditors: upside capped (interest + principal), loss if firm value falls below the debt, but rank ahead of shareholders.
This difference drives shareholders toward riskier choices than creditors prefer.
Main mitigation tools
Managers: pay, board, audit, takeover threat. Creditors: covenants, collateral. Minority holders: voting rights, disclosure, independent directors.
Match the tool to the conflict.

How to solve Principal-Agent Conflicts and Stakeholder Conflicts questions

Use this approach for any conflict question. The three-option format rewards a clear identification of who is in conflict.

  1. 1Identify the two parties in the stem: shareholders and managers, shareholders and creditors, or two groups of shareholders.
  2. 2Decide who is the principal and who is the agent, or which party gains and which loses.
  3. 3Name the diverging interest: pay, perks, risk, dividends, leverage, control or information.
  4. 4Check the action described. Higher risk or extra debt or a large dividend usually favours shareholders and hurts creditors. Perks or low effort usually favour managers.
  5. 5Look for the matching mitigation: incentive pay or board oversight, covenants, or protections for minority holders.
  6. 6Eliminate options that pair a conflict with the wrong remedy or reverse the winner and loser.
  7. 7If the question asks about cost type, classify it: monitoring, bonding or residual loss.

Quickest way: Who gains, who loses, which tool

When to use it: Use for most conceptual questions where you have about 90 seconds.

  1. Underline the two parties.
  2. Ask: who gains from the action? The other party is usually the loser.
  3. Pick the tool: managers need incentives and oversight, creditors need covenants, minority holders need rights and disclosure.
  4. Cross out the two options that mismatch the party or reverse the effect.

Common mistakes in Principal-Agent Conflicts and Stakeholder Conflicts

  • Saying managers are the principals and shareholders are the agents.

    Managers run the firm, so students assume they are in charge.

    Fix: The principal is the one who hires. Shareholders (through the board) hire managers, so managers are agents.

  • Thinking higher leverage always hurts shareholders in a creditor conflict.

    Students confuse the shareholder-creditor conflict with a risk-averse view of debt.

    Fix: Extra debt or risky projects can raise shareholder value at creditors' expense. Creditors are the ones harmed, and they respond with covenants.

  • Classifying a lost profitable opportunity as a monitoring cost.

    Students treat every agency cost as spending.

    Fix: Value lost despite controls is the residual loss. Monitoring costs are paid to oversee the agent, such as audit fees.

  • Treating stock options as a fix with no downside.

    Alignment sounds perfect in theory.

    Fix: Equity pay aligns managers with shareholders but can encourage excess risk-taking or short-term focus, which can worsen shareholder-creditor conflict.

  • Confusing conflicts between shareholder classes with manager-shareholder conflicts.

    Both involve control and perks.

    Fix: If the stem compares holders with different voting rights or a controlling holder and minorities, it is a shareholder-shareholder conflict.

Worked examples

Example 1

A firm's board approves a large special dividend funded by new borrowing, leaving the firm much more leveraged. Which party is most likely harmed by this action? A. Shareholders. B. Creditors. C. Managers.

Show the solution
  1. Parties: the debt-funded dividend moves cash out of the firm to shareholders, so the firm has fewer assets backing its claims and more debt.
  2. Creditors now face a higher risk of non-payment, so their claims become riskier and lose value, and wealth can shift toward shareholders. Creditors are the party harmed.
  3. Option A names the party that stands to gain, not the one harmed. Option C is not the party whose claims become riskier here.
  4. Creditors would protect themselves with covenants that limit dividends and new borrowing.

Answer: B

Example 2

A CEO uses company funds for a private jet that adds no value, and shareholders pay an external firm to audit expenses each year. How are these items classified? A. Jet: residual loss; audit fee: monitoring cost. B. Jet: bonding cost; audit fee: residual loss. C. Jet: monitoring cost; audit fee: monitoring cost.

Show the solution
  1. The jet is value lost to the manager's self-interest. It is not money spent to control the agent, so it is a residual loss.
  2. The audit fee is money shareholders spend to oversee management, which is a monitoring cost.
  3. Option B wrongly calls the jet a bonding cost (the agent does not commit to anything here) and wrongly calls the audit fee residual loss.
  4. Option C wrongly treats the jet as a cost of oversight.

Answer: A

Exam tips

  • Always label principal and agent first. Many wrong options swap them.
  • Memorise the three agency cost types: monitoring, bonding, residual loss.
  • For shareholder-creditor questions, think risk shifting, extra debt and dividends, and the answer is usually covenants.
  • Read for the word 'controlling' or 'voting rights'. It signals a shareholder-shareholder conflict and a remedy based on disclosure and independent directors.
  • This topic is conceptual and rarely needs calculations. Use the time on careful reading of each stem and its options, and answer every question because there is no penalty for a wrong answer.

Practice questions from Investors and Other Stakeholders

Principal-Agent Conflicts and Stakeholder Conflicts in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Principal-Agent Conflicts and Stakeholder Conflicts: frequently asked questions

What is the principal-agent problem in CFA Level I?

It is the conflict that arises when an agent acting for a principal has different interests. In corporate issuers, shareholders are principals and managers are agents. Information asymmetry makes it hard for owners to check what managers do.

How can agency conflicts between managers and shareholders be reduced?

Use equity-linked pay, an independent and effective board, audits and disclosure, shareholder voting rights, and the threat of takeover. These either align goals or increase oversight.

Why do shareholders and creditors conflict?

Shareholders have limited liability and unlimited upside, so they may prefer riskier projects, more debt or bigger dividends. Creditors earn only interest and principal, so they bear the extra risk. Covenants and collateral protect creditors.

What are agency costs?

They are the costs that arise from the principal-agent conflict. They are monitoring costs, bonding costs and residual loss.