Agency Costs in Capital Structure Decisions

Medium Capital Structure Decisions Agency Costs

Company XYZ is a mid-sized enterprise that has been experiencing rapid growth over the past few years. As the company's profitability has increased, management is considering whether to finance its expansion through debt or equity. The decision-makers are aware of the potential agency costs that arise from their financing choices.

Agency costs occur when there is a conflict of interest between stakeholders, such as shareholders and management. A higher debt level could align management's interests with shareholders' interests by promoting a focus on profitability to meet debt obligations. However, it could also create potential risks including taking excessive risks to generate higher returns, which may not benefit shareholders in the long term.

Which of the following statements best illustrates the impact of agency costs in the capital structure decision of Company XYZ?

Higher debt levels may discourage management from pursuing overly risky projects, reducing agency costs.

Equity financing aligns management's interests with those of shareholders, eliminating agency costs.

Increased debt may lead management to engage in riskier behavior to achieve higher returns, increasing agency costs.

Hint

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