ExpertMinds LogoExpertMinds
Medium2 marksMultiple Choice
Financial Management FunctionSection AFinancial Management FunctionAgency Theory

ACCA · Question 15 · Financial Management Function

Section A

MetroWater Utility is experiencing an agency problem. Directors are rejecting positive NPV projects that have long payback periods because their annual bonuses are tied strictly to short-term Return on Capital Employed (ROCE) targets.

Which of the following changes to the directors' remuneration package would best align their interests with the long-term wealth maximization of the shareholders?

Answer options:

A.

Increasing the fixed base salary and removing all performance-related bonuses.

B.

Replacing the ROCE bonus with Executive Share Options that vest after five years.

C.

Changing the bonus target from ROCE to short-term Earnings Per Share (EPS).

D.

Paying the ROCE bonus in shares rather than cash, but allowing immediate sale.

How to approach this question

Identify the root cause of the agency problem: short-termism. Look for a remuneration strategy that forces directors to care about the long-term value of the company.

Full Answer

B.Replacing the ROCE bonus with Executive Share Options that vest after five years.✓ Correct
The agency problem here is caused by short-termism; directors are avoiding good long-term projects to protect their current year's bonus. By replacing the short-term ROCE target with Executive Share Options that cannot be exercised for five years, directors are incentivized to undertake projects that will increase the share price over the long term, aligning their goals with those of the shareholders.

Common mistakes

Selecting EPS (Option C) - EPS is also a short-term accounting metric and suffers from similar flaws to ROCE in this context.
14All questions16.1

Practice the full ACCA FM — Financial Management Practice Exam 5

32 questions · hints · full answers · grading

Sign up freeTake the exam

More questions from this exam

Q01**Section A** The Global Clean Water Initiative is a non-governmental organization (NGO) focused...EasyQ02**Section A** NeuroTech Prosthetics, a high-growth medical technology startup, is seeking additi...MediumQ03**Section A** AeroCater Services provides specialized inflight meals to commercial airlines. The...MediumQ04**Section A** AgriNutrient Co requires 50,000 tonnes of raw phosphate annually for its fertilize...EasyQ05**Section A** SolarGrid Municipal is evaluating a new solar farm project. At a discount rate of ...Medium
View all 32 questions →