Question

13. Argue how having debt in capital structure might be a mitigating factor for agency costs

Answer 1

The use of debt impacts agency cost in several ways.

The use of borrowings decrease the available free cash flow (FCF) to managers as promised as there is interest payments associated to borrowings reduces free cash flow available for investment. This reduction in FCF also helps in overcoming overinvestment problem

The use of borrowings in capital structure also increases monitoring of managers by debt holders like financial institution and banks. They have to recover the interest so they put pressure on managers to earn minimum return to repay the debt.

The introduction of debt also poses threat of bankruptcy. The creditor have legal right to take the bank to court. This creates pressure on managers to run the business profitable and reduce costs.