Agency Costs in Capital Structure Decisions

Very Hard Capital Structure Decisions Agency Costs

Consider a company, XYZ Corp, that is currently financed through a combination of debt and equity. The management team is contemplating increasing its debt level to finance a new project. However, they are aware of the potential impacts on the agency costs associated with this capital structure decision.

Agency costs can arise from conflicts of interest between shareholders and debt holders. Increased debt may lead to actions by shareholders that prioritize their interests at the expense of debt holders, potentially increasing the likelihood of default or risky projects.

Which of the following statements best describes the implications of agency costs related to an increase in debt for XYZ Corp?

Increasing the debt level will align the interests of shareholders and debt holders, effectively reducing agency costs.

Higher debt increases the potential for agency costs due to conflicts of interest, leading to a higher likelihood of risky project selection by management.

Agency costs will remain unaffected by changes in capital structure as long as borrowing costs are stable.

Hint

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