Agency Cost Of Debt

  

An agency cost comes up when the interests of the managers of a company are different from the interests of the owners (See: Agency Cost).

One key example comes up in the decision whether or not to take on debt. For an owner or shareholder, taking on debt has the potential for highly negative consequences. Once in debt, their company owes that money to someone.

But managers don't face the same issues. For the managers, having large amounts of cash to spend is beneficial. They can take chances and grow the company, or maybe just pay themselves a large salary.

If things go south, the managers might lose their jobs, but it won't be their responsibility to repay the loans. That burden falls on the owners, who might be saddled with debt long after the managers have moved on to other jobs, or have retired to some tropical island famous for its mai-tais.

Thus the relative costs and benefits of taking on debt are different for managers than it is for the owners they work for. The managers are agents of the owners, theoretically working for them and promoting the owners' interest, but they might have their own ideas of what is the best course of action, just because the consequences don't hit everyone equally.

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Finance: What is Debt-to-EBITDA?58 Views

00:00

finance a la shmoop what is the debt to EBITDA ratio alright people well

00:08

anytime you see that to in there a pretty good chance we're dealing with a [Person writes ratio on chalkboard]

00:11

ratio and yeah this one's a ratio that compares what a company owes in debt to

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its EBITDA or earnings before interest taxes depreciation and amortization

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otherwise lovingly known on Wall Street as cash flow like the cash it produces [Cash falls from sky]

00:27

alright well the numbers used by bankers and investors to see how leveraged is a

00:30

company is and evaluate its creditworthiness the higher the number

00:34

the more likely it is that a company will struggle to pay up its debt.. Well,

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let's use a couple of practical examples here, a demo;

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if your friend Deb wants

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to borrow five grand from you maybe Deb just doesn't want her pops to

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know she you know dented the car she's not the best driver in the world and

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Deb's a two on the friend reliability scale like you totally trust her and [Deb moving side to side on reliability scale]

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she's a lawyer and makes hundreds of thousands of dollars a year suing people

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for stuff all right well after living expenses she has cash flow personally of

01:08

some fifty grand a year that she socks away in a mattress you know what she [Deb places cash under mattress]

01:12

sleeps on so you'd go ahead and make the loan to Deborah and you'd have no doubt

01:17

that she has the dough to pay you back your five grand the debt to EBITDA in

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this situation five grand over 50 grand or one to ten or 0.1 very low debt to

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EBITDA ratio there very safe bet she'll pay you back your five grand

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well this logic applies to loaning companies money as well the five grand [Man discussing loans outside Amazon building]

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in debt is quote money good unquote and you don't lose sleep over loaning them

01:43

that money if they have good credit and low debt to EBITDA doubt ratios right they

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have more than enough cash flow to cover that debt well so then what's bad debt

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to EBITDA ratio like what does that look like well it's when you have debt

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of more than three or four five times cash flow some companies go even higher [Bad debt-to-EBITDA ratio example]

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so if whatever dot-com has 50 million dollars in cash flow but three hundred

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million dollars in debt that's a really high debt to EBITDA ratio of three

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hundred over fifty or six to one or you just say

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6x if that debt costs a 8% a year to rent well then the total cost just to pay

02:19

interest is 24 mil or almost half of all the company's cash flow for the entire

02:25

company and remember they got to be paying down the principal as they go [Whatever.com's cash flow debt]

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along as well so it's a huge percentage of their cash flow just goes to the bank

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should whatever com stumble and maybe you don't know interest rates go up as

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well well then things could get ugly really fast and yes even uglier than [Deb driving a car in a storm]

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this so yeah you want low debt to EBITDA ratios not high ones unless you're a

02:45

real dice roller there [Debt laid in hospital bed]

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