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CS Executive · Corporate Accounting and Financial Management · Introduction to Financial Management

A company's manager, who owns no shares, rejects a profitable but risky expansion because it could threaten his job security, even though shareholders would gain. Which statement correctly identifies this situation and a standard remedy?

This is an agency problem, where the manager acts in personal interest instead of maximising shareholder wealth. It is mitigated by aligning incentives, such as employee stock options or performance-linked pay, along with monitoring and disclosure. Debt, dividends or depreciation changes do not resolve the conflict of interest.

  1. AAgency problem between managers and shareholders; remedy is aligning pay with shareholder value, such as through employee stock optionsCorrect
  2. BLiquidity problem; remedy is raising more debt
  3. CDividend problem; remedy is paying higher dividends
  4. DTaxation problem; remedy is changing the depreciation method

Explanation

When managers (agents) act in their own interest rather than that of owners (principals), an agency conflict arises. Linking managerial rewards to share value, for example through stock options and monitoring, aligns interests. Raising debt or changing dividends does not address the divergence in incentives.

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