Question

according to agency theory, the existence of debt imposes agency costs. Explain why an increase in debt would increase agency costs?

Answer 1

An agency relationship occurs when a principal hires an agent to perform some services. An agency problem or cost arises when there is a conflict of interest between the needs of the principal and the needs of the agent. Since the agent and the principal may have different goals, the agency relationship creates a potential conflict of interest.The term "agency cost" refers to an instance when an agent's behaviour has deviated from a principal's interest. Agency costs consists of expenses that are associated with managing the relationship and resolving different priorities.

In case when there is debt-funding in the organization, agency costs may be characterized into various costs such as monitoring costs, which is generally borne by the bondholder, the opportunity cost of the wealth, which is faced by the bondholder and bankruptcy costs, which arises due to the increase in the risk to the firm of going bankrupt due to a high degree of leverage in capital structure.

Agency costs are incurred when the owner-manager uses debt finance in the business because of its leveraging benefits, even if there is no benefit of a tax shield. Therefore, the owner-manager will bear all the costs of value reduction of the firm due to the principal-agent relationship but in the contrary, his/her wealth maximization is higher as they can invest their wealth in highly profitable ventures. Due to the fact that, the bondholder is also a rational investor, there will be monitoring costs which can be factored into the value of the debt and the interest payments. The bondholder will issue rules in order to restrict the behavior of the management.

Bankruptcy costs are the major reason why generally most of the firms are not funded with high levels of debt. It is the probability that the company may be unable to meet its payments and will prove as a matter of concern to the bondholders.

This all proves that an increase in debt will lead to an increase in agency costs.