A:

Agency cost of debt refers to an increase in cost of debt when the interests of shareholders and management diverge. For this reason, debt suppliers, like bondholders, impose certain restrictions on companies (via bond indentures) because of a fear of agency-cost problems. The suppliers of debt financing are aware of two things: a) Management is in control of their money, and b) There are high chances of principal-agent problems in any company. In order to mitigate any losses due to managerial hubris, the debt suppliers place some constraints on the use of their money.

In general, the agency cost of debt happens when management engages in projects or behaviors that benefit shareholders more than bondholders. For example, taking on riskier projects could benefit shareholders more while taking more risk means higher chances that debt bondholders hold will default.

The principal-agent problem deals with a lack of symmetry between the desires of the agent and the principal. Principal-agent problem is usually between the shareholders of a company and the agents that run the company (CEO and other executives). When the executives do things that are in their own best interests and not to the benefit of shareholders, then there is an agency problem in the company. (Learn more about the principal-agent problem in our CFA Level 1 Tutorial.)

This question was answered by Joseph Nguyen

RELATED FAQS
  1. How does agency theory propose to deal with the agency problem?

    Learn more about agency theory and how businesses may use it to understand employee-employer relations. Find out more about ... Read Answer >>
  2. How do modern corporations deal with agency problems?

    Learn about ways that capitalist investment markets regulate the principal-agent problems that arise with corporate management ... Read Answer >>
  3. Do negative externalities affect financial markets?

    Learn how negative externalities affect financial markets where parties to financial transactions do not pay full costs for ... Read Answer >>
  4. How is the principle agent problem manifested in the government?

    Learn more about the principal-agent problem and challenges this problem may create in the relationship between government ... Read Answer >>
  5. What are some famous scandals that demonstrate the agency problem?

    Learn more about the agency problem and find a few famous examples. Find out what contributes to these problems and how investors ... Read Answer >>
Related Articles
  1. Small Business

    What are Principal-Agent Problems?

    Principal-agent problems arise when a principal employs an agent to perform duties that conflict with the agent’s best interests.
  2. Investing

    Understanding the Principal-Agent Relationship

    In a principal-agent relationship, one party hires another to act on the former’s behalf.
  3. Investing

    Explaining Agency Costs

    Agency costs are incurred when there is conflict between a company’s management – or its agent – and the company’s principals – or its shareholders.
  4. Investing

    Debt Exchanges Are The Latest Push

    Many companies are trying to cut debt levels by exchanging existing debt for a combination of new debt, cash and stock.
  5. Investing

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  6. Investing

    What's a Debt Security?

    A debt security is a financial instrument issued by a company (usually a publicly traded corporation) and sold to an investor.
  7. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  8. Financial Advisor

    The 4 Best Debt Reduction Services

    It can be tricky to find the best debt reduction services for your financial situation. These top 4 debt consolidation firms help make the process easier.
  9. Investing

    Evaluating A Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  10. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
RELATED TERMS
  1. Principal-Agent Problem

    The principal-agent problem develops when a principal creates ...
  2. Agency Costs

    A type of internal cost that arises from, or must be paid to, ...
  3. Principal-Agent Relationship

    An arrangement in which one entity legally appoints another to ...
  4. Asset Substitution Problem

    A problem that arises when a company exchanges its low-risk assets ...
  5. Agency Cost Of Debt

    A problem arising from the conflict of interested created by ...
  6. Cost Of Debt

    The effective rate that a company pays on its current debt. This ...
Hot Definitions
  1. Trumponomics

    Trumponomics is a term for the economic policies of President-elect Donald Trump.
  2. Universal Health Care Coverage

    An organized healthcare system that provides healthcare benefits to all persons in a specified region. Many countries, such ...
  3. Davos World Economic Forum

    The annual meeting of the World Economic Forum hosted at Davos—a small ski town in Switzerland—in January each year is among ...
  4. Smart Home

    A convenient home setup where appliances and devices can be automatically controlled remotely from anywhere in the world ...
  5. Efficient Frontier

    A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a ...
  6. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
Trading Center