What do you mean by agency problem between shareholders and creditors?

The agency problem between shareholders and creditors arises due to conflicting interests when managers (agents) act on behalf of shareholders (principals) while also considering the interests of creditors. Shareholders, as residual claimants, may pursue high-risk projects to maximize returns, which increases the likelihood of firm failure and reduces creditors’ repayment prospects. This underinvestment problem occurs because shareholders may avoid positive-NPV projects that benefit creditors but dilute their equity value in case of bankruptcy. Conversely, asset substitution happens when shareholders take excessive risks, jeopardizing creditors’ claims. These conflicts lead to higher borrowing costs for firms, as creditors demand compensation for perceived risks. Proper governance, covenants, and monitoring mechanisms help mitigate such conflicts.