Agency costs _____.
A) increase as the debt/total assets ratio decreases
B) affect the present value of the tax shield
C) decrease as financial distress increases
D) reduce the market value of the levered firm

Question

Quizplus · Accepted Answer

Agency costs refer to the costs incurred by a firm due to conflicts of interest between stakeholders, such as shareholders and management. One of the main ways to mitigate agency costs is through the use of debt financing, as creditors have a legal right to demand repayment and can thus limit the actions of management. However, excessive debt can also increase the risk of financial distress and bankruptcy, leading to higher agency costs. As a result, the market value of a levered firm can be lower due to the presence of agency costs. Therefore, D is the best answer. A is incorrect because agency costs tend to be lower when more debt is used. B is also incorrect because the tax shield is not directly related to agency costs. C is incorrect because financial distress can lead to higher agency costs.

Agency Costs _____