An agency issue is most apt to develop when:
the control of a firm is separated from the firm’s ownership.
the firm’s owner is also its key manager.
a firm encounters a period of stagnant growth.
a firm is structured as a general partnership.
a firm downsizes
The correct answer and explanation is:
Correct Answer:
The control of a firm is separated from the firm’s ownership.
Explanation:
An agency issue arises when there is a conflict of interest between the owners (principals) of a firm and the managers (agents) who are hired to run the firm on the owners’ behalf. This problem is most apt to develop when the control of a firm is separated from its ownership because the goals and incentives of managers may not align with those of the shareholders.
In situations where the ownership and control are separate, shareholders (owners) delegate decision-making authority to managers. However, managers may pursue their own interests, such as maximizing personal benefits, job security, or short-term gains, rather than focusing on the long-term value of the firm, which is the primary goal of the shareholders. This creates the principal-agent problem, a key concept in corporate governance.
Why Other Options Are Incorrect:
- The firm’s owner is also its key manager: If the owner is the key manager, there is no separation of ownership and control, and therefore no agency issue arises. The owner’s interests and the firm’s objectives are directly aligned.
- A firm encounters a period of stagnant growth: Stagnant growth can lead to management challenges but does not directly cause an agency issue. The principal-agent problem is rooted in ownership-control separation, not in the firm’s performance.
- A firm is structured as a general partnership: In a general partnership, partners are both owners and managers, so their interests are aligned, minimizing the likelihood of an agency issue.
- A firm downsizes: Downsizing reflects a strategic or operational decision, which could result from internal or external pressures but is not directly related to the separation of ownership and control.
Additional Insights:
To mitigate agency issues, firms can adopt mechanisms such as performance-based compensation (e.g., stock options), shareholder monitoring, or governance structures like independent boards of directors. These strategies align managers’ incentives with shareholders’ goals, reducing potential conflicts. However, as long as ownership and control are separate, the risk of an agency issue remains inherent to corporate structures like publicly traded firms.