What is Agency Cost of Debt
Agency cost of debt is a problem arising from the conflict of interest created by the separation of management from ownership (the stockholders) in a publicly-owned company. Corporate governance mechanisms, such as boards of directors and the issuance of debt, are used in an attempt to reduce this conflict of interest. However, introducing debt into the picture creates yet another potential conflict of interest because there are three parties involved: owners, managers and lenders (bondholders), each with different goals.
BREAKING DOWN Agency Cost of Debt
For example, managers may want to engage in risky actions they hope will benefit shareholders, who seek a high rate of return. Bondholders, who are typically interested in a safer investment, may want to place restrictions on the use of their money to reduce risk. The costs resulting from these conflicts are known as the agency cost of debt.
With managers in control of their money, the chances that there are principal-agent problems are quite high. These problems deal with a lack of consistency between the desires of the principal (shareholders) and the agent (management). Management may make strategic decisions that are in their own best interests rather than shareholders or bondholders.
Implementing debt covenants allows lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business. Covenants are often represented in terms of key financial ratios that are required to be maintained, such as a maximum debt-to-asset ratio. They can cover working capital levels or even the retention of key employees. If a covenant is broken, the lender typically has the right to call back the debt obligation from the borrower.
There are a number of regulations and laws that define the relationship between the principal and the agent that aim to minimize the effects of the conflict of interest. Companies also incur large costs to pay external auditors to assess the company’s financial statements for accuracy and legal compliance.
Minimizing Agency Costs
Taking steps to incentivize an agent to act in the principal's best interests may additionally help reduce the problems surrounding agency costs. For example, performance-based compensation such as profit sharing or stock options, or even a variety of non-monetary incentives may successfully motivate management to better act in the best interests of principals.
Although these incentives are actually agency costs, they are meant to help provide added benefits for shareholders and lenders in excess of the costs of implementing.