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IAI Actuarial Core Principles · Business Finance · Ethical responsibilities of owners and managers

A company's board links a large part of the chief executive's remuneration to the share price through share options. Which agency cost is this arrangement mainly intended to reduce, and which new risk can it create?

Share options aim to align managers' interests with shareholders by tying pay to share price, reducing the agency problem. The risk is that managers may take excessive risks, focus on short-term price gains or manipulate reported figures to lift the price and the value of their options.

  1. AIt reduces monitoring by auditors, but creates a risk of higher audit fees
  2. BIt aligns managers' interests with shareholders, but may encourage short-term share price manipulation or excessive risk-takingCorrect
  3. CIt transfers control to creditors, but creates a risk of lower dividends
  4. DIt removes the need for independent directors, but creates a risk of lower disclosure
  5. It guarantees managers' job security, but creates a risk of lower pay

Explanation

Share-based pay is a bonding mechanism that aligns manager and shareholder interests. However, because options have limited downside for the holder, managers may take excessive risk or focus on short-term price or manipulate reported results. The other options mis-state the purpose or effects.

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