Agency Cost of Debt: Definition, Minimizing, Vs. Cost of Equity

What Is Agency Cost of Debt?

The agency cost of debt is the conflict of interest between shareholders and debtholders or creditors of a firm based on the decisions made by management. The agency costs of debt would specifically be the actions taken by debtholders in restricting what management can do with their capital if they believe that management favors actions that would help shareholders instead of debtholders.

The agency cost of debt is often paired with the agency cost of equity, which is the conflict of interest that arises between management the shareholders.

How Agency Cost of Debt Works

Public companies are complex machines that have a variety of players. All of these players are aligned in that they want the business to succeed, however, certain actions lead to certain players benefiting more, which creates conflicts of interest.

For example, managers may want to engage in risky actions they hope will benefit shareholders, who seek a high rate of return. Debtholders, 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 for debtholders are quite high. 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 (debtholder) and the agent (management), aimed to minimize the effects of the conflict of interest.

Agency Cost of Debt vs. Agency Cost of 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 interest of the firm and that shareholders view 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 business, whereas the shareholders see that the merger would not help grow the business, and the money spent on the merger could be better used in paying dividends and investing in other areas.

The costs associated with stopping the merger, such as lobbying, would be the agency costs of equity.

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.

However, stock options would align management with shareholders rather than bondholders, which would reduce the agency cost of equity but increase the agency cost of debt.

Some ways to ensure that both agency costs of equity and debt are reduced include the following: ensuring that management and the business adhere to budget planning, performing accurate accounting, implementing limits on business expenses, such as when traveling, and programs to increase employee satisfaction, which would reduce costs related to employee turnover.