What are agency costs and how do they affect corporate financing decisions?

Agency costs arise when the interests of one group (agents) don't align with another group (principals). In corporate finance, there are two primary conflicts:

1. Shareholder-Manager Conflict (Agency Cost of Equity): Managers (agents) may not act in shareholders' (principals') best interests because they:

• Prefer empire building (acquiring companies to increase their power/prestige, even at negative NPV)
• Consume excessive perks (corporate jets, lavish offices)
• Avoid risky but positive-NPV projects to protect their job security
• Entrench themselves with golden parachutes and poison pills

2. Shareholder-Bondholder Conflict (Agency Cost of Debt): Once debt is issued, shareholders have incentives to:

• Asset substitution: Replace low-risk assets with high-risk ones (shareholders capture upside, bondholders bear downside)
• Underinvestment: Reject positive-NPV projects if most of the benefit goes to bondholders (debt overhang)
• Cash stripping: Pay excessive dividends, leaving less to cover debt obligations

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Mitigation Mechanisms:

For equity agency costs:

• Performance-based compensation (stock options, restricted stock)
• Board oversight and independent directors
• Threat of takeover (market for corporate control)
• Leverage as discipline: Debt forces managers to generate cash for payments, reducing free cash flow available for wasteful spending (Jensen's free cash flow hypothesis)

For debt agency costs:

• Restrictive covenants: Limits on additional borrowing, dividend payments, asset sales
• Collateral requirements: Secured debt reduces incentive for asset substitution
• Convertible bonds: Align interests (bondholders share upside through conversion)
• Short-maturity debt: Forces frequent refinancing, maintaining market discipline

Worked Example: Oakvale Industries has $200 million in free cash flow but limited growth opportunities. Without debt, management invests in unprofitable acquisitions (empire building). If the board mandates$150 million in annual debt payments, only $50 million remains for discretionary investment, forcing management to be selective. This is the 'discipline of debt' argument for leveraged firms with mature cash flows.

Understand how agency costs shape real-world corporate decisions in our CFA Level II course materials.