Agency Costs of Debt and Equity

A manager runs a company using other people's money — shareholders' equity, lenders' debt — and does not personally bear the full consequences of every decision. That gap between who decides and who pays is called an agency problem, and it shows up differently depending on whether the "other people" are shareholders or lenders. Both sides anticipate the manager's incentive to act against them, and both build in protections that themselves cost the company money. Those protective costs, plus whatever value is still lost despite them, are the agency costs of capital structure.

Equity's problem: managers spending someone else's money

When a manager owns only a small slice of the company, the cost of a lavish headquarters, an empire-building acquisition, or simply coasting rather than working hard is shared with all shareholders but felt personally by the manager as almost nothing. This is the classic free cash flow problem: cash sitting on the balance sheet is tempting to spend on pet projects with poor returns rather than return to shareholders. Shareholders respond with monitoring costs — audits, board oversight, equity-linked pay meant to align incentives — all of which are real expenses that reduce the value shareholders ultimately capture.

Debt's problem: shareholders gambling with lenders' money

Once debt is outstanding, equity holders have an odd asymmetric incentive. Debt is a fixed claim: lenders get their coupon and principal back and nothing more, no matter how well the company does. Equity is the residual claim: if a risky bet pays off, shareholders keep all the upside past what's owed to lenders; if it fails, lenders absorb much of the downside because there's nothing left for equity anyway. That asymmetry pushes equity holders — and the managers who answer to them — toward excessive risk-taking (the "asset substitution" problem) precisely when the company is already heavily levered, since shareholders have little left to lose. It also creates the debt overhang problem: even a genuinely good new project may get rejected if too much of its payoff would flow to existing lenders before shareholders see anything.

A worked example

A company has $100m of assets funded entirely by $100m of debt (an extreme case for clarity) and is choosing between two projects. Project A is safe: it returns $110m with certainty. Project B is risky: 50% chance of $150m, 50% chance of $40m, an expected value of $95m — worse than Project A on average.

Lenders are owed $100m regardless. Under Project A, equity gets 110 - 100 = $10m with certainty. Under Project B, equity gets $\max(150-100, 0) =$ $50m with 50% probability, or $0 with 50% probability (since $40m isn't even enough to repay the $100m debt, lenders simply take the $40m and equity gets nothing) — an expected equity payoff of $0.5 \times 50 + 0.5 \times 0 =$ $25m, more than double Project A's $10m, even though Project B has a lower expected value overall. Equity holders, and the managers acting for them, are incentivized to gamble with lenders' money precisely because the downside is capped at zero for equity while the upside is not. Lenders anticipate exactly this and write covenants — restrictions on new risky investments, minimum coverage ratios, limits on new debt — into the loan agreement to block it, and charge a higher coupon to compensate for whatever risk-shifting the covenants can't fully prevent.