Question

What steps can stockholders take to reduce the cost of debt? What incentives for stockholders have to do this? Are there any instances where managers’ interests and shareholders’ interests might diverge in their desire to minimize the cost of debt? Explain.

Answer 1

STEPS TO REDUCE COST OF DEBT

1.BY CUTTING DEBT FINANCING COSTS, LOWERING EQUITY COSTS AND CAPITAL RESTRUCTURING.

HERE EQUITY COSTS COMPRISES OF COMMON STOCK AND RETAINED EARNINGS, THE COST OF EQUITY INCORPORATES THE SCOPE OF INHERENT RISK PREMIUM LURKING IN THE PROFITABILITY PROSPECTS OF THE COMPANY.

DEBT FINANCING COSTS : HIGHER THE RATE IS THE HIGHER THE RISK OF COST INVOLVED.

CAPITAL STRUCTURE : IT SHOULD COMPRISE OF OPTIMUM MIX OF BOTH DEBT AND EQUITY.

Incentives for stockholders have to do this: MAKE STRATEGIC DECISIONS THAT MAXIMIZE EXPECTED VALUE, EVEN AT EXPENSE OF LOWERING NEAR TERM EARNINGS.

managers’ interests and shareholders’ interests might diverge in their desire to minimize the cost of debt

YES, THIS IS ALSO KNOWN AS AGENCY COST OF DEBT, A PROBLEM ARISING FROM THE CONFLICT OF INTEREST CREATED BY THE SEPARATION OF MANAGEMENT FROM OWNERSHIP IN A PUBLICLY OWNED COMPANY.

CORPORATE GOVERNANCE MECHANISM, SUCH AS BOARD OF DIRECTORS AND THE ISSUANCE OF DEBT, ARE USED IN ATTEMPT TO REDUCE THIS CONFLICT OF INTEREST. HOWEVER, INTRODUCING DEBT INTO PICTURE CREATES YET ANOTHER POTENTIAL CONFLICT OF INTEREST BECAUSE THERE ARE PARTIES INVOLVED : OWNERS, MANAGERS, LENDERS, EACH WITH DIFFERENT GOALS.