Question

Briefly explain how the use of debt and leverage can reduce agency costs and increase firm value (3-4 sentences preferred).

Answer 1

Agency cost is associated with the conflicting interest of the management and the shareholders of the company. The management acts as the agent of the shareholders. When management starts increasing their own perquisites and wealth at the expense of the shareholders' value, it leads to agency costs.

Use of debt can reduce this conflict and increase the firm's value by:

1. Reducing the amount of free cash flow available to the management to play with.
2. Adding the scrutinization by the lenders (eg. banks, corporations) of the management activities.
3. Fear of bankruptcy in case of default in debt will make the management to invest in less risky and more rewarding projects.
4. Getting advantage of tax shields on interest payments also results in an increase in the firm's value.

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