Question

Question 2:
Suppose that you are hired as a consultant to a large retail chain of apparel stores. As the company has grown, the CEO (also the owner) and the stock analysts who follow the company have noticed that the newly opened stores are not meeting sales projections. The CEO wants you to find out what is causing this problem and fix it. You do investigation and learn that the business development managers in the company are responsible for finding new store locations and negotiating leases with property owners. The company rewards the business development managers with stock options, provided that they open 5 new stores in a single year. Each new store is expected to have potential sales of at least $2 million per year. However those newly open stores can only achieve half of this amount. As a consultant, you are required to answer following questions.

1. Describe the principal-agent relationship. Who is making the bad

   decisions? Explain.

2. Do the agents have enough information to make a good decision?

   Explain.

3. Do the agents have incentives to make a good decision? Explain.

4. Based on your answers to (a), (b) and (c), discuss the centralization

   and decentralization solutions to resolve the principle-agent conflicts.

5. Based on your answer to (d), what solution will you propose. Justify

your choice.

Answer 1

A. The principal agent relationship when one party (principal) appoints another party (agent) to take decisions on their behalf. The agent here (business development managers) are making the bad decisions.

B. Yes the agent have enough ifnormation. They are the ones choosing the location and hence know the area demographics, location type etc and hence know whether the store will earn high revenue or not.

C. No the agents do not have the incentive to make the right decisions. Their payout depends only on the fact that they open at least 5 stores, not on the revenue the stores earn thereafter.

D. Decentralization, meaning getting agents involved in the decision making process to, results in bringing the agents and principals closer and hence solves the principal agent problem to a certain degree. If the agents are also part of the decision making process, they will take decisions which benefit all.

E. The solution I will propose that the incentive be changed in such a way that also takes revenue per store into account, and the business development managers be also involved in deciding the correct balance between number of stores and revenue.