Can anyone explain briefly why might agency cost rise steeply beyond a certain level of gearing? (Chapter 16 - page 11) Regards, Krithika
I think if gearing gets too high, then the debtholders have such a large interest in the company that the shareholders may be tempted to go for big "all or nothing" risks - the upside has high potential for shareholders, but the downside is the debtholders get left to pick up the pieces. So, the interests of shareholders and debtholders are way out of line - an example of agency costs.
I think the point we're making in the Course Notes is that, as gearing increases, the risk to the business increases, and so the management team is likely to be more cautious - and, in particular, too cautious for the shareholders. This increases agency costs as the shareholders have to spend more time checking up on the managers.
Another question related to Agency Cost: Why would auditor's fee be conidered as Agency Cost? Regards, Krithika
Directors and auditors report to shareholders; directors as trustees of shareholders and auditors as watch dogs. The auditors' report is addressed to shareholders. Hence the cost of audit services is indeed an agency cost.
