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

In a listed Indian company, the promoters hold a controlling stake while the day-to-day running of the business is handled by professional managers. Which statement best describes the classic agency problem that arises in this relationship between shareholders (principals) and managers (agents)?

The classic agency problem is that managers, who control the business, may act in their own interest, for instance through excessive pay, perks or empire building, rather than maximising shareholder wealth, because ownership and control are separated.

  1. AManagers may pursue their own interests, such as higher pay or empire building, at the expense of shareholder wealthCorrect
  2. BShareholders may refuse to receive dividends, which prevents managers from investing
  3. CManagers are legally barred from taking any investment decisions without a shareholder vote
  4. DCreditors always bear the full cost of managerial decisions
  5. Managers and shareholders always have identical risk preferences, so conflict arises only from taxation

Explanation

The agency problem arises because ownership and control are separated and managers' objectives can differ from those of shareholders. Managers may prefer perks, size or job security over maximising shareholder value. The other options misdescribe the legal position or the parties involved.

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