Chapter 16

Question 1

Debt overhang problem

Answer 1

Arises from a firms existing debt causes it to pass up positive NPV projects because the cost of borrowing is too high.
- EH believe the existing debt will take all the projects benefits (through debt interest payments)
- firms w senior DH may not get additional debt financing (so internal funds must be used -> not an EH fav)
- taking on more projects is costly and risky for EH and with risky debt present EH would rather have internal funds paid out as dividends

Question 2

Asset substitution problem

Answer 2

With high leverage EH ignore the positive NPV rule and take on riskier investments because this transfers wealth from DH to EH
- prevents firm from getting new debt at any interest rate when RFR are high
- EH prefer high risk, low NPV over high NPV low risk projects.

Question 3

Shortsighted investment problem

Answer 3

In Highly leveraged firms EH will pick projects that have lower NPV but shorter time horizon to stay afloat rather than better projects with long term payoff horizons

Question 4

Reluctance to liquidate

Answer 4

EH want to keep a firm operating even when its liquidation value > operating value
- DH have priority in the event of liquidation, ∴ DH benefits, but EH is residual claimant and may not get anything in liquidation but may benefit from upside if firm keeps running

Question 5

How to mitigate conflicts

Answer 5

Debt overhang problem: Going into administration -> get additional financing that is senior to existing debt.

Asset substitution problem (taking on risky projects): protective covenants on loans

Asset substitution problem: choosing short term over long term debt -> borrowing rate is renegotiated at the end of each period.

Shortsighted investor problem: management compensation contracts -> tie up managers own wealth to the firms success so they act in a risk-averse manner and in the interest of DH

Question 6

More Methods that owners can use to minimize incentive costs

Answer 6

• project financing: mitigates asset substitution problem; getting financing for a specific project means less transfer of wealth from EH to DH thus less incentive to pass up positive NPV projects
• convertible bonds: removes EH incentive to take on risky projects because value of bonds is insensitive to volatility changes.

Question 7

Exam technique (which project would the firm choose?)

Answer 7

Means the EH are choosing since they own the firm.
- compare returns to EH for each project then choose
- then how would DH would feel and why?