Agency Cost of Debt
What Is Agency Cost of Debt?
The agency cost of debt is the conflict of interest between shareholders and debtholders or [creditors](/loan boss) of a firm based on the choices made by management. The agency costs of debt would specifically be the actions taken by debtholders in limiting how management can manage their capital assuming they accept that management favors actions that would help shareholders rather than debtholders.
The agency cost of debt is frequently paired with the agency cost of equity, which is the conflict of interest that emerges between management the shareholders.
How Agency Cost of Debt Works
Public companies are complex machines that have various players. These players are adjusted in that they believe the business should succeed, in any case, certain actions lead to certain players benefiting more, which makes conflicts of interest.
For instance, managers might need to participate in dangerous actions they hope will benefit shareholders, who look for a high rate of return. Debtholders, who are typically interested in a more secure investment, might need to place limitations on the utilization of their money to reduce risk. The costs coming about because of these conflicts are known as the agency cost of debt.
With managers in control of their money, the possibilities that there are principal-agent problems for debtholders are very high. Carrying out debt covenants permits lenders to shield themselves from borrowers defaulting on their obligations due to financial actions hindering to themselves or the business.
Covenants are many times addressed in terms of key financial ratios that are required to be kept up with, for example, a maximum debt-to-resource ratio. They can cover working capital levels or even the retention of key employees. In the event that a covenant is broken, the lender typically has the option to call back the debt commitment from the borrower.
There are a number of regulations and regulations that characterize the relationship between the principal (debtholder) and the agent (management), planned to limit the effects of the conflict of interest.
Agency Cost of Debt versus Agency Cost of Equity
Agency cost of equity alludes to the conflict of interest that emerges among management and shareholders. At the point when management settles on choices that probably won't be to the greatest advantage of the firm and that shareholders view as an action that won't increase the value of their shares, an agency cost of equity has emerged.
For instance, management might accept that a merger would be the best step forward for the business, while the shareholders see that the merger wouldn't assist with developing the business, and the money spent on the merger could be better utilized in paying dividends and investing in different areas.
The costs associated with halting the merger, for example, campaigning, would be the agency costs of equity.
Limiting Agency Costs
Making moves to boost an agent to act in the principal's best interests may also assist with diminishing the problems encompassing agency costs. For instance, [performance-based compensation](/performancecompensation, for example, profit sharing or stock options, or even various non-money related incentives, may effectively spur management to better act to the greatest advantage of principals.
Notwithstanding, stock options would adjust management to shareholders instead of bondholders, which would reduce the agency cost of equity yet increase the agency cost of debt.
Far to guarantee that both agency costs of equity and debt are reduced incorporate the accompanying: guaranteeing that management and the business stick to budget planning, performing accurate accounting, carrying out limits on business expenses, for example, while voyaging, and programs to increase employee satisfaction, which would reduce costs connected with employee turnover.
Highlights
- The agency cost of debt is the conflict that emerges among shareholders and debtholders of a public company.
- Debtholders normally place covenants on the utilization of capital, like adherence to certain financial metrics, which, whenever broken, permits the debtholders to call back their capital.
- Agency costs of debt emerge when debtholders place limits on the utilization of their capital assuming they accept that management will make moves that favor shareholders rather than debtholders.
- The agency cost of equity is when there exists a conflict of interest among management and shareholders.
- There are various ways of decreasing both equity and debt agency costs, which incorporate fitting budget planning, adherence to accounting principles, limits on business expenses, and the implementation of employee programs.
