Agency Cost of Debt

This is originally posted on Wednesday, 13 February 2013 at 14:15

2011 ZA 2b

Outline the arguments for the agency cost of debt. Explain how the use of convertible bonds might mitigate the agency conflict betwenn equity holders and debt holders in financially distressed firms with high debt-to-equity ratios. 

The Agency Cost of Debt is examined by Jensen & Meckling (1976) and Myers (1977). Perceiving the agency cost of debt from different angles, Jensen & Meckling identified the Risk Shifting (aka Asset Substitution) Problem while Myers identified the Debt Overhang Problem. Although the problems identified are distinct, the agency costs accosiated with both problems can be observed from two dimensions:

1. Corporate managers prioritize the interests of equity holders over debt holders. This leads to sub-optimal managerial decisions in investment and capital allocation. The result will be a firm value which is sub-optimal.

More specifically, the value of debt is sub-optimal; debt holders do not receive their potential payments because of sub-optimal managerial decisions: projects with positive NPV are rejected (Debt Overhang Problem), managers take on riskier projects that provide lower expected returns (Risk Shifting Problem), opportunistic behavior where managers divert resources into riskier projects upon sucessful issuing of debt (Asset Substitution Problem).  

3. The additional costs of creating, monitoring and enforcing the corporate governance structure and restrictive clauses in debt covenants to safeguard the interests of debt-holders. 

The higher the face value of debt and Debt-to-Equity Ratio, the greater the agency costs of debt.