1. What Are Agency Costs, and How Are Agency Costs of Financial Distress Different from Agency Benefits of Leverage? Explain Their Impact on Calculating the Value of a Firm with Financial Distress.
Agency costs arise when conflicts of interest occur among stakeholders and must be paid out to an agent acting on behalf of a principal. According to Peavler (2013), “There is an agency cost that exists in every business that has owners or shareholders and managers who are not necessarily owners. Agency cost means that shareholders and business managers may not necessarily agree on the actions that are best for the business firm and that there is an inherent cost to that disagreement. That leads to what is called the agency problem.” When a firm has leverage, a conflict of interest exists if investment decisions have dissimilar consequences for the value of equity and the value of debt. These conflicts happen when there is a high concern of financial distress and can only arise when there is a chance that the firm will default. For example, if the firm managers’ actions are positive for the shareholders but negative for the firm’s creditors which, in turn, lowers the overall total value of the firm. Shareholders wish for management to run the company in a way that increases shareholder value. On the other hand, management may wish to grow the company in ways that capitalize on their personal power and goals that may not be in the best welfare of shareholders.
Agency costs of financial distress are different from agency benefits of leverage because even though equity holders may benefit at the expense of debt holders’ from these negative NPV actions taken in times of distress, debt holders recognize this move and pay less for the debt when it is first issued, reducing the amount the firm can dole out to shareholders. The net result is a reduction in the initial share price of the firm corresponding to the negative NPV of the actions. Ultimately, it is the shareholders of the firm who swallow these agency costs. Agency costs represent an additional cost of growing the firm’s leverage that will affect the firm’s optimal capital structure choice. The costs increase
Agency costs of financial distress are different from agency benefits of leverage because even though equity holders may benefit at the expense of debt holders’ from these negative NPV actions taken in times of distress, debt holders recognize this move and pay less for the debt when it is first issued, reducing the amount the firm can dole out to shareholders. The net result is a reduction in the initial share price of the firm corresponding to the negative NPV of the actions. Ultimately, it is the shareholders of the firm who swallow these agency costs. Agency costs represent an additional cost of growing the firm’s leverage that will affect the firm’s optimal capital structure choice. The costs increase