Agency cost of debt refers to an increase in cost of debt when the interests of shareholders and management diverge in a publicly owned company. There are certain types of corporate governance, such as boards of directors and the issuance of debt, that attempt to reduce this conflict of interest. However, introducing debt into the picture creates yet another potential conflict of interest because owners, managers and bondholders each have different goals.
Why Are Certain Restrictions Imposed?
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:
- Management is in control of their money
- Chances are high that there are principal-agent problems in any company.
In order to mitigate any losses due to managerial hubris, debt suppliers place some constraints on the use of their money.
When Benefits and Risks Don't Match Up Evenly
In general, 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 provide a greater benefit to shareholders. While taking on more risk means higher chances that the company will be in default to bondholders.
The principal-agent problem deals with a lack of symmetry between the desires of the principal and the agent. A 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.)