Question

Describe agency costs and the impact on bondholders.(150 words and no plagirism please)

Answer 1

Agency costs are those arising between the principal and the agent, and include 'the costs of drawing up and enforcing a contract, as well as transaction costs, moral hazard costs and information costs. Agency cost is the sum of monitoring costs and residual loss

Agency cost can arise due to conflict of interests between shareholders and managers, shareholders and bondholders. Bondholders suffer opportunity wealth loss due to a firm's investment, financing and dividend decision. If the firm sells bonds, and the bonds are priced assuming that no additional debt will be issued, the bond holders claim gets diluted if the firm issues additional debt of the same or higher priority. Due to claim dilution, bond holders suffer capital loss. Agency problems stem from conflicts of interest, and capital structure management encompasses a natural conflict between stockholders and bondholders. Acting in the stockholders' best interests might cause management to invest in extremely risky projects. Existing investors in the firm's bonds could logically take a dim view of such an investment policy.