Agency cost refers to the cost incurred by a firm because of the problems associated with the different interests of management and shareholder and the information asymmetry that exists between the principal (shareholders) and the agent (management).
Agency Cost of Equity
The agency cost of equity arises because of the difference in interests between the shareholders and the management. As long as the management’s interests diverge from that of the shareholders, the shareholders will have to bear this cost. Management may be tempted to take suboptimal decisions that may not work towards maximizing the value for the firm. Any measures implemented to oversee and prevent this will have a cost associated with it. So, the agency costs will include both, the cost due to the suboptimal decision, and the cost incurred in monitoring the management to prevent them from taking these decisions.
Agency Cost of Debt
The agency cost of debt arises because of different interests of shareholders and debt-holders. Assume that the management is in favour of the shareholders. If so, the management can in many ways transfer the wealth to the shareholders and leaving debt-holders empty handed. Anticipating such activities, the debt-holders will take various preventive measures to disallow management from doing so. The debt holders may do so in the form of higher interest rates to protect themselves from the losses. Alternatively they may impose restrictive covenants.
One example of such behaviour is seen in the priority given to dividends. In their pursuit to please the shareholders, the management may give cash dividends to the shareholders, leaving very less to pay to the debt holders. To avoid this situation, there is this requirement that the interest must be paid before dividends.
Similarly there are other situations where such covenants are placed, for example, debts with different seniority.
In general, we can say that the management is more information about the prospects of the business compared to shareholders, debt-holders and other parties. This is called information asymmetry.
The information asymmetry directly affects the agency costs: the higher the information asymmetry, the greater will be the agency costs.