AGENCY COST OF DEBT

A problem arising from the conflict of interested created by the separation of management from ownership (the stockholders) in a publicly owned company. Corporate governance mechanisms, such as boards of directors and the issuance of debt, are used in an attempt to reduce this conflict of interest. However, introducing debt into the picture creates yet another potential conflict of interest because there are three parties involved: owners, managers and lenders (bondholders), each with different goals.

For example, managers may want to engage in risky actions they hope will benefit shareholders, who seek a high rate of return. Bondholders, who are typically interested in a safer investment, may want to place restrictions on the use of their money to reduce their risk. The costs resulting from these conflicts are known as the agency cost of debt.