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

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