The contract is drawn to ensure management act in the best interest of shareholders and the shareholders on the other hand undertake to compensate the management for their effort Examples of the costs are: Negotiation fees The legal costs of drawing the contracts fees.
Add Insight to your inbox. While debt financing assists a firm in many ways including reduction in free cash flow problem, shielding tax and avoiding dilution of equity ownership structure, it creates a potential conflict of interests between shareholders and bondholders of the firm.
An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. Shareholders can threatened to sell their shares to competitors. Conflict between interests of shareholders and managers of a firm causes the firm to lose some of its value.
Financial Analysts Journal, 54 3 Managers take action to increase the stockholders wealth rather than maximizing the total value of the firm Examples of such behaviors are taking risky projects with negative NPV.
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The most significant is the first case that the shorter maturities bonds are the best alternate to solve the agency problem between shareholder and bond holder Easterwood and Kadapakkam, The internal shareholders want their benefits or vote for their benefits while the external vote or want their own benefits Sundaramurthy and Lyon, This paper concluded that if a firm has high inside ownership that will have a high debt ratio as compared to the firm which having low inside ownership.
In this case the management team is fired and those who stay on can loose their control and influence in the new firm.