An agency cost comes up when the interests of the managers of a company are different from the interests of the owners (See: Agency Cost).
One key example comes up in the decision whether or not to take on debt. For an owner or shareholder, taking on debt has the potential for highly negative consequences. Once in debt, their company owes that money to someone.
But managers don't face the same issues. For the managers, having large amounts of cash to spend is beneficial. They can take chances and grow the company, or maybe just pay themselves a large salary.
If things go south, the managers might lose their jobs, but it won't be their responsibility to repay the loans. That burden falls on the owners, who might be saddled with debt long after the managers have moved on to other jobs, or have retired to some tropical island famous for its mai-tais.
Thus the relative costs and benefits of taking on debt are different for managers than it is for the owners they work for. The managers are agents of the owners, theoretically working for them and promoting the owners' interest, but they might have their own ideas of what is the best course of action, just because the consequences don't hit everyone equally.
Related or Semi-related Video
Finance: What are Debt Service and Debt ...3 Views
Finance, a la shmoop. What is debt service and debt service ratios? Well debt
service is just the interest you pay on debt in a given year. Like you're [Definition written on a 100 dollar bill]
servicing the debt, like think about the oil demanded by a robot in a year she
demands to be serviced and the oil you serve her will you know quench her [Robot drinking oil]
thirst. Well debt service can be easy or it can
be hard, like whatever.com has 50 million bucks of 6 percent debt costing 3 [The debt service calculation is shown]
million a year to service. Well if whatever.com had 40 million bucks in [Vault full of money]
cash profits servicing its debt would then be easy and it would have a debt [Someone repeatedly pressing an easy button]
service ratio of 40 over 3 or 13 and 1/3 times coverage. Said another way the odds [The ratio calculation is shown]
that whatever.com would find itself in a position that it couldn't service
its debt are well very low. But think about the other side of the coin if [Somone about to flip a coin]
whatever.com had only 4 million dollars in cash profits well then it's debt
service ratio is 4 over 3 meaning that 75% of its cash flow leaves the company [Money going from whatever.com to the lenders]
and goes into the coffers of the kindly loving lenders who are nervous about the
company falling into default and going bankrupt which does not make the oil go
down easy... [Robot drinks oil and spits it out]
Up Next
What is Debt-to-EBITDA? Debt to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is a ratio that calculates Debt to net earn...