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CA Intermediate · Financial Management and Strategic Management · Scope and Objectives of Financial Management

Vikram Pharma Ltd.'s board offers its CEO a large stock option plan so that the CEO's decisions align with shareholders' interests. Meanwhile, lenders include covenants restricting additional borrowing and dividend payouts. Which statement about these arrangements, in the context of agency theory, is correct?

Both arrangements are agency costs. Stock options align managers' interests with shareholders, while lender covenants limit shareholders' and managers' actions that could harm creditors. Each is a mechanism to reduce conflicts between principals and agents.

  1. ABoth arrangements are agency costs incurred to reduce conflicts between principals and agentsCorrect
  2. BStock options reduce the manager-shareholder conflict, but lender covenants are irrelevant to agency problems
  3. CStock options create a conflict between managers and lenders, while covenants remove the conflict between managers and shareholders
  4. DBoth arrangements are incurred only to maximise profit and have no link with agency relationships

Explanation

Agency problems arise between shareholders and managers, and between shareholders and creditors. Stock options (monitoring/incentive) and covenants (restricting actions) are both agency costs meant to reduce these conflicts. Covenants address the shareholder-creditor conflict, so calling them irrelevant is wrong.

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