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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
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
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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.]
- b. $40,000– $80,000 [this range would result in expected compensation below $80,000 and thus would be insufficient to entice the franchisee to participate.]
- c. $60,000– $100,000 [this would allow the franchisee to earn an average salary similar to the
manager but still allow it to vary with performance.]
- d. $80,000– $100,000 [If a manager requires total compensation of $80,000, then the franchisee should earn roughly $80,000 on average.]
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10. In the magazine Budget Travel , a hotel maid admits, “ I cut corners everywhere I could. Instead of vacuuming, I found that just picking up the larger crumbs from the carpet would do. Rather than scrub the tub with hot water, sometimes it was just a spray and- wipe kind of day.… After several weeks on the job, I discovered that the staff leader who inspected the rooms couldn’t tell the difference between a clean sink and one that was simply dry, so I would often just run a rag over the wet spots.… I apologize to you now if you ever stayed in one of my rooms.” Which of the following organizational forms is more likely to have caused this kind of shirking?
- a. Franchising: where the hotel managers are the owners of the hotel (franchisee) and pay a fixed franchise fee [As owners, hotel managers receive the profit of the hotel as earnings and thus have a lot of incentive to maintain the quality of the hotel.]
- b. Company-owned hotels [As managers do not share (as much) in the profits of the hotels, they have less incentive to monitor quality than the other two organizational forms.]
- c. Franchising with a sharing contract, where the hotel managers are the owners of the hotel (franchisee),
but they pay a smaller fixed fee to the franchisor, but share revenue with the franchisor. [As owners, hotel managers’ earnings vary with the profit of the hotel, providing a lot of incentive to maintain the quality of the hotel.]
• d. None of the above [incentives to shirk vary with organizational form.]
