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ACCA Applied Knowledge · Business and Technology · Governance in business organisations

The directors of Harlow Co, a listed company, approve a large expansion project mainly because it will increase the size of the business and their own status and pay, even though the expected return is below the cost of capital. Which of the following BEST describes the agency problem illustrated?

The situation shows managers pursuing their own interests, such as status and pay, at the expense of shareholders. Shareholders are the principals and directors their agents, so choosing a project returning less than the cost of capital for personal gain is the classic agency problem of divergent interests.

  1. AManagers pursuing their own interests at the expense of the shareholders who appointed themCorrect
  2. BShareholders exercising excessive control over the day-to-day decisions of the directors
  3. CDirectors acting as agents of lenders who have required security over the company's assets

Explanation

In an agency relationship, shareholders (principals) appoint directors (agents) to act in their interests. Here the directors choose a project that benefits themselves (status and pay) while destroying shareholder value, which is the classic agency problem arising from divergent interests. The second option reverses the relationship, and the third misidentifies the principals as lenders.

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