Question

How do agency costs and free cash flow relate to capital structure management?

Answer 1

Agency cost means all such cost which are incurred in relation with management of agency relationship of shareholders and management of the company and these cost will be leading to decrease in the overall free cash flows of the firm instantly because this will lead to increase in cost and in addition and this will also lead to performance based payment to the management who are acting as agent of the shareholder so this will be leading to overall decrease in the free cash flows of the company and it would in turn impact be overall capital structure of the company as there would be less focus on the debt capital and more focused on equity.

Capital structure Management related to management of debt capital and equity capital in the overall structure of the company and debt capital are often associated with interest tax deduction and they are provided with interest tax shield so all the interest payable to the debt capital are tax deductible in nature and hence the cost of debtcapital will be less than the cost of equity capital and it will be lowering down the overall cost of capital so use of debt capital is to be compared with need of the firm and need of the equity shareholders in order to fulfill their obligation related to agency cost.

It is also to be traded off between the cost of financial distress related with their capital and interest tax benefit related with debt capital, So, the overall agency cost will be impacting the capital structure of the company in Adverse way so there has to be better management of resources so that agency costs should be paid out and an optimal capital structure should be maintained while avoiding all such agency conflicts in the company in order to maximize the value of company.

So, agency cost and free cash flows are relatable to the overall capital structure of the company for maximization of the value of the shareholder and sustainable growth of the company.