Question

Which one of the following actions by a financial manager is most apt to create an agency problem?

A. agreeing to pay bonuses based on the market value of the company stock rather than on the firm's level of sales

B. increasing current profits when doing so lowers the value of the firm's equity

C. refusing to expand the company if doing so will lower the value of the equity

D. refusing to borrow money when doing so will create losses for the firm

refusing to lower selling prices if doing so will reduce the net profits

Answer 1

Answer:B. increasing current profits when doing so lowers the value of the firm's equity

True.Agency problem refers to the conflict of interest that occurs in a relationship where one party is supposed to act in the best interest of the other.Here the manager(agent) is supposed to act in the best interest of the investors (owners). Managers are often paid on the basis of the profits they generate for the firm.Investors on the other hand require an increase in value of equity so that they can gain from the change in share price.So a manager increasing the profits even if it lowers value of equity indicates an agency problem.

Other options explained

A. A. agreeing to pay bonuses based on the market value of the company stock rather than on the firm's level of sales

False.Since there is no agency problem here both the interest of the shareholders and that of the manager are protected.

C. refusing to expand the company if doing so will lower the value of the equity

False.No conflict of interest since the interest of both the principal and agent are protected.

D.refusing to borrow money when doing so will create losses for the firm

refusing to lower selling prices if doing so will reduce the net profits

False.Since there is no conflict of interest since both decrease in net profit and incurring losses are not in the best interest of both principal and agent.