What Is Agency Cost of Debt?

The agency cost of debt is the conflict of interest between 澳洲幸运5开奖号码历史查询:shareholders and 澳洲幸运5开奖号码历史查询:debtholders or 澳洲幸运5开奖号码历史查询:creditors of a firm based on the decisions made by management. The agency costs of debt would specifically be the actions taken by debtholders in restricting what management can do with their capital if they believe that management favors ac𝕴tions that would help shareholders i🍨nstead of debtholders.

The agency cost of debt is often paired with the agency cost of equity, which is the conflict of interest that arises between managemenꦰt the shareholders.

How Agency Cost of Debt Works

Public companies are complex machines that have a variety of players. All of these players are aligned in that they want the business to succeed, however, certain acﷺtions lead to certain players benefiting more, which creates conflic✅ts of interest.

For example, managers may want to engage in risky actions they hope will benefit shareholders, who seek a high 澳洲幸运5开奖号码历史查询:rate of return. Debtholders, who are typically interested in a safer investment, may want to place restrictions on the use of their money to reduce risk. The costs result𒉰ing from these conflicts are known 💃as the agency cost of debt. 

With managers in control of their money, the chances that there are 澳洲幸运5开奖号码历史查询:principal-agent problems for debtholders are quite high. Implementing debt 澳洲幸运5开奖号码历史查询:covenants allows lenders to protect themselves from borrowers defaulting on their obligation🥃s due to financial actions detrimental to themselves🍸 or the business.

Covenants are often represented in terms of key financial ratios that are required to be maintained, such as a maximum 澳洲幸运5开奖号码历史查询:debt-to-asset ratio. They can cover 澳洲幸运5开奖号码历史查询:working capital levels or even the retention of key employees. If a covenant is broken, the lender typically has the right to call bac🗹k the debt obligation from the borꦫrower.

There are a number of regulations and laws that define the relationship between the principal (debtholder) and the 🔜agent (management), aimed to minimize the effects of the conflict of interest.

Agency Cost of Debt vs. Agency Cost of Equity

Agency cost of equity refers to th෴e conflict of interest that arises between management and shareholders. When management makes decisions that might not be in the best interest of the firm and that shareholders view as an action that will not increase the value of their shares, an agency cost of equity has arisen.

For example, management may believe that a merger would be the best step forward for the business, whereas the shareholders see that the merger would not help grow the business, and the money spent on the merger could be better used in paying 澳洲幸运5开奖号码历史查询:dividends and investing in other areas.

The costs associated with s𒅌topping the merger, such as lobbying, would be the agency ꦑcosts of equity.

Minimizing Agency Costs

Taking steps to incentivize an agent to act in the principal's best interests may additionally help reduce the problems surrounding agency costs. For example, 澳洲幸运5开奖号码历史查询:performance-based compensation, such as profit sharing or 澳洲幸运5开奖号码历史查询:stock options, or even a variety of non-monetary incentives, may successfully motivate management to bett🐬er act in the best interests of principals.

However, stock options would align management with shareholders rather than bondholde🎉rs, which would reduce the agency cost of equity b🤡ut increase the agency cost of debt.

Some ways to ensure that both agency costs of equity and debt are reduced💟 include the following: ensuring that management and the business adhere to budget planning, performing accurate accounting, implementing limits on business expenses, such as when traveling, and programs to increase employee satisfaction, which would reduce costs related t🎀o employee turnover.