Question

Which of the following would be best considered to be a principal-agent problem between investor/owners and financial managers?

A. Sue instructs her staff to skip safety inspections in one of the company's factories because she thinks her boss wants to avoid those costs.

B. Michael chooses to enhance his firm's reputation at some cost to its shareholders by sponsoring a team of athletes for the Special Olympics.

C. Bill uses company funds to pursue a risky investment project which is very unlikely to be successful, because his personal compensation will increase if the firm takes on the project.

Answer 1

The principal agent problem also known as agency problem is often between the shareholders of a company and the managers where the managers takes action which benefit them at the expense of shareholder. The correct option is

C. Bill uses company funds to pursue a risky investment project which is very unlikely to be successful, because his personal compensation will increase if the firm takes on the project.

Here even though the project is very risky the manager is taking up the project in order to increase his compensation. This is an example of agency problem where at the agent is not acting in the beast interest of shareholder.

Option A is more a fault in safety procedure and option B is appropriate given the manager is incurring the cost to enhance the reputation of the company.