Do Agency Costs Matter for Optimal Capital Structure?

Abstract

I show that agency costs are irrelevant in determining optimal capital structure, in the sense that variations in capital structure induced by agency costs have no impact on firm value, if all agents have common and rational prior beliefs about future states of the world, project-choice control can be costlessly allocated to any party in each state, and there are no taxes. This conclusion is robust to assuming that only the manager can have project-choice control or that the only outsiders with project-choice control are the bondholders or that states are unobservable to any party that does not have project choice control. However, when the common-prior-beliefs assumption is dropped and the model is extended to allow equally-informed agents to disagree over firm value, a link emerges between capital structure and firm value even if allocating state-contingent project-choice control to any party is costless.