Agency Cost Of Debt Contracting Essay

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The agency theory examines the relationship between the principle and agent under the assumption that that individuals act in their own self-interest in order to maximise their personal wealth. This conflict of interest creates agency costs that are borne by the principle. The agency problem is apparent in debt contacting relationships where the firm is assumed to be acting in the interests of its shareholders when borrowing money from the debt holders. Agency costs are incurred by the debt-holder when a firm engages in opportunistic behaviours in an attempt to expropriate wealth away from its debt holder. As a result, the debt holder faces an increased risk of lending the funds to the firm. There are four common opportunistic actions that firm can take in order to expropriate wealth from its debt holder
Black (as cited in Smith and Warner, 1979) states that “there is no easier way for a company to escape the burden of debt than to pay out all of its assets in the form of dividend, and leave the creditors holding an empty shell”. In this situation, the firm promises the debt holder to maintain a consistent dividend policy at the time of borrowing funds but later increases the rate of dividends. According to Smith and Warner (1979), the increase in dividend policy reduces the value of the debt and ultimately, increases the risk to the debt holders. The firm is being opportunistic because debt holders

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