Pepperdine University

FINC 655

Chapter 21

Multiple Choice Questions

1)Your notebook computer’ s hard drive recently crashed, and you decide to take it to a local repair technician to have it fixed. In this relationship,

• a. you are the agent. [the agent typically is the party actually performing the work.]
• b. the technician is the principal. [the principal typically is the party contracting an agent to perform the work.]
• c. the technician is the agent. [the technician is being contracted by you, the principal, to do the

work.]

• d. no principal-agent relationship exists. [assuming that the repair technician has any interests that are not identical to yours, a principal-agent relationship exists.]

2. A good compensation scheme

• a. maximizes the agent's utility. [the goal of a compensation scheme is to maximize the principal’s profit.]
• b. anticipates how an agent will game the scheme. [agents may find ways to maximize their profit in ways not anticipated by the principal.]
• c. does not subject a risk-averse agent to risk. [incentive compensation usually involves some risk for the

agent, for which he or she has to be compensated.]

• d. accompanies centralized decision-making authority. [compensation schemes are especially important when decision-making authority is decentralized.]

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3. Principal-agent relationships

• a. reduce monitoring costs. [principal-agent relationships are often characterized by high monitoring costs and thus often rely on incentive pay.]
• b. occur because managers have good information about employees. [principal-agent relationships exist in

many environments, including ones where principals have very little information about their employees.]

• c. are not related to asymmetric information. [agents having better information about their capabilities and actions is typical of principal-agent problems.]
• d. are subject to moral hazard problems. [principals may be unable to observe or monitor agents’

actions.]

4. All of the costs associated with a principal interacting with an agent are called

• a. opportunity costs [these are the costs of foregone opportunities.]
• b. agency costs [these include the costs of combatting moral hazard and adverse selection]
• c. monitoring costs [this is just one type of cost associated with principal-agent relationships.]
• d. sunk costs [these are costs that do not vary with the consequences of your decision.]

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5. Principal-agent problems

• a. occur when firm managers have more incentive to maximize profit than shareholders do. [the problem generally occurs because the manager has less incentive to maximize profit.]
• b. help explain why equity investments are an important financing source for firms.
• c. would not arise if firm owners had complete information about the actions of the firm’s managers. [correct]
• d. are increased as more information is shared between the parties. [reducing information asymmetry also

reduces principal-agent problems.]

6. In order to create an effective incentive compensation scheme, you must have

• a. adequate performance measures. [compensation schemes tie rewards to performance and therefore require that performance be reliably measured.]
• b. unlimited funds. [incentive compensation schemes align the incentives of the agent with that of the

principal, but this does not require unlimited funds.]

• c. a flat management structure. [a specific management structure is not a precondition for an effective compensation scheme.]
• d. None of the above [one of the above answers is

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7. Decentralization of decision-making authority is consistent with which of the following?

• a. A trend of stronger, more active CEOs. [this would be consistent with centralization of authority]
• b. Shrinking costs of computing bandwidth, which allows information to be inexpensively aggregated from geographically diverse business units. [When information is easier to aggregate, centralized decision making authority becomes easier to sustain.]
• c. Development of microcomputing resources at the corporate, division, and employee level. [this provides decision-making tools at each level of a corporation, reducing the need to centralize decision- making authority.]
• d. Reduction in the use of incentive compensation. [decentralization of authority is generally accompanied with increased reliance on incentive compensation.]

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8. A firm faces two kinds of employees, those able to sell 10 units/year, and those able to sell 5 units/year. High productivity employees are willing to work for $100/year while low productivity employees are willing to work for only $50/year. To screen out the low productivity employees, the firm should

• a. offer a salary of $100. [Both kinds of employees would accept this salary.]
• b. offer a salary of $75 plus $5/unit commission. [Low productivity employees would not be screened out as they would earn more than $50.]
• c. offer sales commission of $10/unit. [Low productivity employees would not be screened out as they would

earn $10 on each of five units.]

• d. offer a sales commission of $20/unit, on sales above 5 units. [This would sufficiently reward high productivity employees but pay low productivity employees only $20, screening them out.]

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9. You own a retail establishment run by a store manager who receives a flat salary of $80,000. If you set up another store as a franchise with incentive compensation to the franchisee, what would be a reasonable total compensation range that the franchisee could earn?

• a. $80,000 [the franchisee’s compensation should vary with performance.]