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Agency theory and agency costs involving debt

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Agency Theory

According to agency theory, the existence of debt imposes agency costs.

Required:
a. What are agency costs?
b. Explain why an increase in debt would increase agency costs and what the resulting effect would be for debtholders.
c. What strategy might debtholders utilize to counter potential adverse agency effects?

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Solution Summary

The 400 word solution is a comprehensive study of the questions involving agency theory as it pertains to debt. There are numerous examples to illustrate the concepts.

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a. What are agency costs?

The theory says that there are conflicts which arise as a result of one acting as an agent for another. These conflicts can come about between shareholders, bondholders, management, creditors, employees and others whose goals about the company are different from stated goals of the principal - the company.

For example, an agency problem exists when management and stockholders have conflicting ideas on how the company should be run. http://www.investopedia.com/terms/a/agencyproblem.asp

These differences can lead to real costs. In a current real world example, the shareholders of Home Depot are starting an action to block the payment of the $210M contract buyout for the CEO who resigned recently. There ...

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