The theory posts that equity holders and debt holders incur costs associated with monitoring management to ensure that it behaves in ways consistent with the firm’s contractual agreement.
Regardless of who makes the monitoring express the cost is ultimately borne by the shareholders. Debt holders anticipating high monitoring costs charges higher interest rates which lower the value of the firm to its shareholders. The presence monitoring cost acts as a disincentive to the insurance of debt monitoring costs like insolvency costs tend to increase at an increasing with leverage.
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