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. 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 >>
  3. How do you calculate the ratio between debt and equity in the cost of capital

    Discover how to calculate the ratio between debt and equity when making cost of capital estimations using the weighted average ... Read Answer >>
  4. What is the difference between cost of debt capital and cost of equity?

    Learn about how the costs of debt and equity capital differ and how to calculate each using interest and tax rates and stock ... Read Answer >>
  5. What are some examples of a debt management plan (DMP)?

    Learn about some of the different types of debt management plans, and what you should look for when you evaluate a credit ... Read Answer >>
  6. What is a good debt ratio, and what is a bad debt ratio?

    Learn about the factors that influence how investors and lenders evaluate the debt ratio for a company and why the answer ... Read Answer >>
Related Articles
  1. Term

    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. Term

    Understanding the Principal-Agent Relationship

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

    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.
  4. Investing Basics

    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.
  5. Economics

    How Debt Limits A Country's Options

    While debt is fundamentally necessary to the operation of a national government, it can also be limiting and dangerous.
  6. Credit & Loans

    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.
  7. Credit & Loans

    How Countries Deal With Debt

    For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly.
  8. Credit & Loans

    How To Manage And Consolidate Your Own Debt

    With debt management services costing a lot of money, this article looks at why it is better to manage your own financial liability.
  9. Retirement

    Why Retirees Are Carrying More Debt Than Ever

    It was recently discovered that as people reach retirement they are carrying more debt than ever before.
  10. Investing Basics

    Knowing Your Rights As A Shareholder

    We delve into common stock owners' privileges and how to be vigilant in monitoring a company.
RELATED TERMS
  1. Principal-Agent Problem

    The principal-agent problem develops when a principal creates ...
  2. Asset Substitution Problem

    A problem that arises when a company exchanges its low-risk assets ...
  3. Bondholder

    The owner of a government or corporate bond. Being a bondholder ...
  4. Agency Cost Of Debt

    A problem arising from the conflict of interested created by ...
  5. Debt Buyer

    A company that purchases debt from creditors at a discount. Debt ...
  6. Agency Problem

    A conflict of interest inherent in any relationship where one ...
Trading Center