Agency Cost
Non Tax Influences on Capital Structure
Agency Costs
• Asset Substitution Problem
• Underinvestment Problem
• Free Cash Flow
Agency Cost arises when there is a conflict between debtholders & Shareholders.
Asset Substitution Problem - You are on the verge of Debt as a company and as a Manager
you take on a Risky project (Hero or Zero) here are two possibilities that it works out in your
favor, that way Shareholders earn more money (return on their stock or call options) or if it
does not work out in your favor you lose the original investment which is the stock value
goes to 0, which was already about to happen as you are on Bankruptcy. You do not take on
more Debt as the Interest rate would be higher as your Default risk is already higher, and no
one will give you new debt as well in the market.
Underinvestment Problem - This scenario occurs when firm prefers to avoid investing in
positive NPV projects because the benefits of the investments will accrue (go) more to
bondholders than shareholders in financial distress. (As interest are paid before dividend).
Existing shareholders do not want to invest more because primary benefits will go to
bondholders. New shareholders are not likely to invest unless they get a discount because
they feel the same and existing shareholders would refuse for the discount as it would dilute
their shares.
Debt Overhang Problem - The company has so much Debt that it affects its investment
decisions. Burdened so much by debt & every benefits primarily go to Bondholders.
Extreme Case - Cashing Out - Shareholders will sell their assets on Discount or paying out
large dividends when company cant really afford it.
Potential Solution - Debt Restructuring - Extending Payment period, changing interest rates
or Renegotiating contracts.
Free Cash Flow Problem - Managers might use the cash for their pet projects or Hubris
Takeovers the solution could be to Increase Leverage/take more debt or pay higher dividends.
Non Tax Influences on Capital Structure
Agency Costs
• Asset Substitution Problem
• Underinvestment Problem
• Free Cash Flow
Agency Cost arises when there is a conflict between debtholders & Shareholders.
Asset Substitution Problem - You are on the verge of Debt as a company and as a Manager
you take on a Risky project (Hero or Zero) here are two possibilities that it works out in your
favor, that way Shareholders earn more money (return on their stock or call options) or if it
does not work out in your favor you lose the original investment which is the stock value
goes to 0, which was already about to happen as you are on Bankruptcy. You do not take on
more Debt as the Interest rate would be higher as your Default risk is already higher, and no
one will give you new debt as well in the market.
Underinvestment Problem - This scenario occurs when firm prefers to avoid investing in
positive NPV projects because the benefits of the investments will accrue (go) more to
bondholders than shareholders in financial distress. (As interest are paid before dividend).
Existing shareholders do not want to invest more because primary benefits will go to
bondholders. New shareholders are not likely to invest unless they get a discount because
they feel the same and existing shareholders would refuse for the discount as it would dilute
their shares.
Debt Overhang Problem - The company has so much Debt that it affects its investment
decisions. Burdened so much by debt & every benefits primarily go to Bondholders.
Extreme Case - Cashing Out - Shareholders will sell their assets on Discount or paying out
large dividends when company cant really afford it.
Potential Solution - Debt Restructuring - Extending Payment period, changing interest rates
or Renegotiating contracts.
Free Cash Flow Problem - Managers might use the cash for their pet projects or Hubris
Takeovers the solution could be to Increase Leverage/take more debt or pay higher dividends.
