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ACCA Strategic Professional · Strategic Business Leader · Agency

Kestrel Group's board is considering moving executive pay from a fixed salary to a scheme based wholly on share price growth over three years, in order to reduce agency costs. A governance adviser warns of a weakness in this approach. Which warning is most consistent with agency theory's own limits?

Share-based pay can create new agency costs because managers may manipulate short-term results or take excessive risk to lift the share price, and market movements are partly outside their control. The scheme therefore only imperfectly aligns interests and does not remove the agency problem.

  1. AShare-based rewards can encourage managers to manipulate short-term reported results or take excessive risk, creating new agency costs rather than eliminating themCorrect
  2. BShare price growth is impossible to measure, so the scheme cannot be operated
  3. CExecutives will always become more risk averse once they hold shares, so the scheme will reduce innovation
  4. DThe scheme transfers the agency relationship to employees, who become principals of the board

Explanation

Incentive schemes aim to align interests but can introduce perverse behaviour such as earnings manipulation or high risk-taking to lift share price, and share prices are influenced by factors outside managers' control. So agency costs are reshaped, not removed. The claim that executives always become risk averse is not supported and ignores option-like payoffs.

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