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ACCA Strategic Professional · Advanced Financial Management · Financial strategy formulation

Brelko Ltd's chief executive receives a bonus based entirely on this year's profit after tax. The CEO proposes cancelling a research project with a positive NPV because its cost would reduce current-year profit. Which agency problem does this most clearly illustrate, and what is the most appropriate mitigation?

This is managerial short-termism, an agency problem where the CEO sacrifices a positive-NPV project to boost current profit and bonus. The best mitigation is to link rewards to long-term shareholder value, for example shares or options vesting over several years, so managers' incentives match shareholders' interests.

  1. AMoral hazard through excessive risk taking; remedy by raising fixed salary
  2. BManagerial short-termism; remedy by linking rewards to long-term measures such as shares or share options vesting over several yearsCorrect
  3. CInformation asymmetry with lenders; remedy by adding debt covenants
  4. DDividend signalling; remedy by cutting the dividend

Explanation

Rejecting a positive-NPV project to protect current profit is short-termism, where managers' goals diverge from shareholder wealth. Rewards tied to long-term value, such as deferred shares or options, align the interests. Raising fixed salary would remove incentive linkage altogether, and covenants address lenders, not this conflict.

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