What are the agency costs of debt and equity?

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AcadiFi · Accepted Answer

Agency costs arise from conflicts of interest between claim-holders when parties have separate incentives. Jensen and Meckling (1976) identify two primary agency conflicts: between managers and equity holders (agency cost of outside equity), and between equity holders and debtholders (agency cost of debt).

Agency cost of outside equity: managers with small ownership stakes may consume perquisites, pursue empire-building acquisitions, shirk effort, or divert resources to private benefits. Outside shareholders incur monitoring costs (boards, auditors, analyst coverage), bonding costs (compensation contracts, restrictive charters), and residual losses. For Trembly Media with dispersed ownership, these costs are significant but partially mitigated through performance-linked compensation and institutional investor oversight.

Agency cost of debt: once debt is in place, equity holders have incentives to (a) asset substitution (switch to higher-risk investments with upside captured by equity, downside borne by debt), (b) underinvestment (Myers 1977 debt overhang: reject positive-NPV projects where benefits flow primarily to debt), (c) dividend payout (strip cash for equity before default), and (d) claim dilution (issue equal-ranking debt that reduces existing bondholders' security). Debtholders anticipate and price these risks via covenants, higher coupons, shorter maturity, and collateral requirements.

Capital structure implication: leverage choice balances tax shield benefits against both sets of agency costs. Firms with growth opportunities and intangible assets (Trembly Media's content library) face higher debt-side agency costs (asset substitution temptation, underinvestment risk) and should carry less debt. Firms with stable tangible assets face lower debt-side agency costs and can support more leverage.

What are the agency costs of debt and equity?

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