Question

According to agency theory, the existence of debt imposes agency costs.

Required: a. What are agency costs?

b. Explain why an increase in debt would increase agency costs and what the resulting effect would be for debt holders.

c. What strategy might debt holders utilize to counter potential adverse agency effects?

Answer 1

(a): Agency costs are those costs that arise due to the existence of an agency arrangement and should be paid to an agent who is acting on behalf of a principal. Agents are hired by principals to act on their behalf and the costs incurred towards this arrangement are known as agency costs.

(b): Increase in debt leads to increase in agency costs. This is because when the quantum of debt increases the chances of potential conflict of interest increases. This is because owners of a company, managers of a company and the bondholders each have a different goal. The resulting effect for debt holders is that increase in debt may dilute their benefits, interests and goals. Also as debt level increases the cost of financial distress also increases. It should be noted that financial distress is a situation in which a company is not able to honor its obligations.

(c): To counter potential adverse agency effects debt holders should make use of covenants to protect their interests and benefits. Covenants are a useful tool to align the interests of the principal and the agent and to an extent align the interests of the borrower and the lender. It should be noted that debt covenants are restrictions that lenders place on lending agreements so that actions of the borrowers are limited.