Question

Which of the following is a conclusion of agency theory?

A. Managers may accept excessive financial risks to increase the returns to shareholders.

B. Managers tend to avoid high-risk, high-return investments that may jeopardize their positions if successful.

C. Managers will always use the least expensive source of funds to finance investments.

D. Managers will tend to put the stockholders interests before their own security and ambitions.

Answer 1

Agency concept is about the problems that exist due to a divorce between the management and the shareholders. The shareholders don't oversee the day to day operations while the management does so the management might use this position to increase their own return at the cost of shareholder's interest.

Now if the management's incentives or salaries are not aligned with that of the shareholders, they will not care if the shareholders lose out. Therefore they might take on excessive risks to increase the profit number as an increased profit would gain them better increments in salaries as the numbers will not show the amount of risk borne and if such projects are unsuccessful then the management doesn't lose anything. So statement A is true about agency problem

Statement B is not true because the management will not be over cautious because of the fear of success of the project but because of the fear of the failure of the project if it has something to lose at the same time.

Statement C is wrong because if there is an agency problem, management would not be too concerned about the cost of raising capital

Statement D is exact opposite of the definition of agency problem and so it is wrong too.