The agency cost is the expense incurred by the company due to the problems associated with the management decisions of the company that affects equity holders and debt holders.

The agency cost consists of agency cost of equity and agency cost of debt. Let us understand the agency cost of debt.

It is the cost of debt that arises due to a conflict of interests between the shareholders and debt holders of a company.

For example, assume that the management of a company favors the equity holders surpassing the debt holders of the company and decides to transfer the wealth at the equity holders end leaving behind the debt holders empty pockets. Forecasting such scenarios, debt holders of the company proactively take measures to safeguard themselves and disallow management from doing so. The debt holders may do so in the form of better interest rates in order to prevent themselves from losses or may possess restrictive covenants.

In the context of such behavior from the management of the company, the dividend is prioritized to please shareholders leaving very little to pay to the debt holders. In order to overcome such a situation, there is this requirement to pay interest before paying off the dividend.

Agency cost of debt arises when debtholders place limits on the use of capital if they sense that the management is favoring the shareholders comparatively.

Management of the company is more informative of the prospects of the businesses as compared to shareholders, debt-holders, and so on. This is termed information asymmetry.

However, the higher information asymmetry directly impacts the agency cost.

In order to ensure that both the agency cost of debt and equity are balanced, several measures on the part of the management of the company need to be followed rigorously such as budget planning, implementing measures to limit the company expenses, regular measures to improvise the employee satisfaction level and so on