Final answer:
The example of an agency cost among the given options is the failure of making the best investment decision. It reflects the conflict of interest between an agent and the principal which is central to the concept of agency costs.
Step-by-step explanation:
An agency cost is a type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal. This cost arises when there is a conflict of interest between the needs of the agent and the needs of the principal. Among the given choices:
- Payment of interest is considered an explicit cost and not an agency cost.
- Costs incurred for setting up an agency can be considered agency costs, but they are not related to the conflict of interest between principals and agents.
- Payment of income tax is an obligation and not related to agency costs.
- Failure of making the best investment decision can be an example of an agency cost, particularly if such failure arises due to the agent's actions that do not align with the best interest of the principal (shareholders).
Therefore, the correct answer to the student's question is d. Failure of making the best investment decision is an example of an agency cost.