What is the cost of agency debt?
The cost of debt agency is the conflict of interest between shareholders and debt holders Where creditors of a company based on decisions made by management. Debt agency costs would specifically be measures taken by debt holders to restrict what management can do with their capital if they feel that management favors actions that would help shareholders rather than debt holders.
Agency cost of debt is often associated with agency cost of equity, which is the conflict of interest that arises between management and shareholders.
Key points to remember
- The agency cost of debt is the conflict that arises between the shareholders and creditors of a public company.
- Debt agency costs arise when debt holders limit the use of their capital if they believe management will take actions that favor shareholders over debt holders.
- Creditors typically impose covenants on the use of capital, such as compliance with certain financial measures, which, in the event of non-compliance, allow creditors to recall their capital.
- The agency cost of equity is when there is a conflict of interest between management and shareholders.
- There are a variety of ways to reduce agency equity and borrowing costs, including proper budget planning, adherence to accounting principles, limits on business expenses, and implementing employee programs.
How the agency’s cost of debt works
State-owned enterprises are complex machines that have a variety of actors. All of these actors are aligned in that they want the business to be successful, however, certain actions cause certain actors to benefit more, which creates conflicts of interest.
For example, executives may want to engage in risky actions that they hope will benefit shareholders, who seek a return rate. Creditors, who are generally 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 issues for creditors are quite high. Debt implementation alliances allows lenders to protect themselves against borrowers defaulting on their obligations due to financial actions harmful to themselves or the business.
Covenants are often represented in terms of key financial ratios that must be maintained, such as a maximum rate of endettement. They can cover working capital levels or even retention of key employees. If a commitment is broken, the lender usually has the right to recall the borrower’s debt.
There are a number of regulations and laws that define the relationship between principal (debt holder) and agent (management), aimed at minimizing the effects of conflict of interest.
Cost of agency debt vs. cost of agency equity
Agency cost of equity refers to the conflict of interest that arises between management and shareholders. When management makes decisions that might not be in the best interests of the business and shareholders view it as an action that will not increase the value of their shares, an agency cost of equity has arisen.
For example, management may believe that a merger would be the best step forward for the company, as shareholders see that the merger would not help the growth of the company, and the money spent on the merger could be better used to pay dividends and invest in other areas.
Costs associated with stopping the merger, such as lobbying, would be equity agency costs.
Minimize agency costs
Taking steps to encourage an attorney to act in the best interests of the principal can also help reduce agency fee issues. For example, performance-based pay, such as profit sharing or stock options, or even a variety of non-monetary incentives, can successfully motivate management to act better in the best interests of constituents.
However, stock options would align management with shareholders rather than bondholders, which would reduce the agency cost of equity but increase the cost of agency debt.
Here are some ways to ensure that agency costs of equity and debt are reduced: make sure management and the business adhere to budget planning, perform accurate accounting, put limits on business expenses, such as travel, and programs to increase employee satisfaction, which would reduce staff turnover costs.