Question

Under positive Accounting Theory, what are agency costs of equity and agency costs of debt? It is possible to put in place mechanisms to reduce all opportunistic action? If not, why not?

Answer 1

Agency costs of equity refer to the costs that are incurred by transferring the authority of decision-making from the shareholders to the management. These arise usually due to the conflict of interests between the shareholders and the management. Sometimes the organization may be allured to make irrelevant and deplorable decisions that may not work towards maximizing the value for the enterprise. Any expedient means implemented to monitor this will have extra monies associated with it. Hence, the agency costs will include both, the costs arising due to the decisions made as well as the cost incurred in monitoring the organisation to prevent them from taking these decisions.

Agency costs of debt refer to the costs arising due to the management’s decisions that benefit the enterprise, at the expense of the debt-holders. These costs would be the firm borrowing excessive monies in form of debt, or may be paying excessive dividends, or investing in high-risk assets from the debts borrowed. These decisions would risk the debt-holders from receiving the payments that are owed to them by the company. Anticipating such decisions, the debt-holders will take various preventive measures to stop management from doing so. They may do so in the form of higher interest rates to protect themselves from the losses. They may impose restrictive terms and conditions too.

No. It is NOT possible to put in place mechanisms to reduce all opportunistic action. The shareholders/owners may practically not be able to predict each and every decision or action that the management makes and hence, it would be too costly to enter into contracts that counters all the opportunistic actions that might be thought about.