Agency costs have a further impact on a firm’s practical financing decisions.
Where gearing is high, the interests of management and shareholders may conflict with those of creditors.
Management may for example:
gamble on highrisk projects to solve problems
pay large dividends to secure company value for themselves
hide problems and cut back on discretionary spending
invest in higher risk business areas than the loan was designated to fund.
In order to safeguard their investments lenders/debentures holders often impose restrictive conditions in the loan agreements that constrains management’s freedom of action.
These may include restrictions:
on the level of dividends
on the level of additional debt that can be raised
on acceptable working capital and other ratios
on management from disposing of any major asset without the debenture holders’ agreement.
These effects may:
encourage use of retained earnings
restrict further borrowing
make new issues less attractive to investors.