Impact of Capital Structure on Agency Costs

Hard Capital Structure Decisions Agency Costs

XYZ Corporation is considering a new capital structure strategy in response to increasing agency costs that have been affecting its shareholder value. The company's management team believes that a significant portion of these agency costs stems from conflicts of interest between shareholders and management, particularly concerning excessive executive compensation and unequal risk allocation. XYZ Corporation's board is evaluating three different financing options: a debt-heavy capital structure, equity financing with a focus on ownership dilution, and a hybrid approach leveraging mezzanine financing.

Given this context, the board wants to understand how each financing option might differently influence agency costs and whether increasing the firm's leverage would exacerbate or mitigate these costs. Specifically, they are interested in the implications of each approach on manager-shareholder dynamics and overall risk exposure.

A debt-heavy capital structure tends to reduce agency costs by increasing managerial risk and aligning their interests with those of the shareholders.

Equity financing, while potentially increasing dilution, can lead to lower agency costs as management may face less risk and thus have less incentive to manipulate outcomes.

A hybrid approach using mezzanine financing can effectively balance risk and return, but may increase agency costs due to complex financing structures.

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