Question

Salary and bonus plans address the agency problem by:

A. Skewing the compensation system toward top management.

B. Permitting the firm to reduce base salaries for all employees.

C. Denying bonuses to employees who make mistakes.

D. Paying extra compensation based on the firm's financial performance.

Answer 1

Agency problem basically is a problem of conflict of interest between company's management and stockholders. Management goal should be maximising shareholder's wealth and they should strive and take decisions which are in the best interests to shareholders. But Agency problem ocuurs if that purpose is not solved.

For example, lets say management is evaluating a project to check if they should take it up. They should go ahead with the project only if it is creating value and is maximising shareholders wealth.Lets say it is decided that the project is not profitable after the valuation.So the project should ideally be rejected.But there may be an incentive offered to the management to accept the project. In this case Agency problem occurs if the management gets lured into it.

So, the best solution to minimise agency risk is to incentivise the management to act in best interests of the shareholders. So, paying extra compensation based on firm's performance will help in doing it.