Lent Term - Lecture 3

Question 1

What is debt overhang?

Answer 1

This is where wealth is transferred to existing debtholders and it discourages investment by shareholders

Question 2

Why do all-equity forms take on all positive NPV projects?

Answer 2

Because the shareholders absorb all of the NPV of the project

Question 3

Why do equity holders invest with safe debt?

Answer 3

The value of equity increases

Question 4

Investing in positive NPV projects can bring increased cash flows. What else can they bring?

Answer 4

They can bring a higher probability of the high cash flow state

Question 5

Why does debt overhang lead to underinvestment?

Answer 5

There are positive NPV projects that should be undertaken but are not because the claim of risky debtholders increases even though they experience no cost

Question 6

What is the condition for debt overhang to materialise?

Answer 6

The debt must be risky. Also, the cash flows cannot be contracted upon separately from the assets in place.

Question 7

Does the debtholders’ payoff change with renegotiation/

Answer 7

No

Question 8

Why is some debt forgiveness conditional?

Answer 8

Because the firm will only invest if the increase in cash flow minus the part of the new cash flow going to shareholders is greater than investment

Question 9

What can firms do ex ante and ex post to mitigate debt overhang?

Answer 9

Ex ante - Try to renegotiate debt and use project financing

Ex post - Issue debt that is senior to existing debt so there is no ‘tax’ by old debtholders

Question 10

What are some implications of debt overhang?

Answer 10

Aside from underinvestment:

1) Firms that undertake projects frequently should have less debt
2) These firms should aim for a structure that is more easily negotiated (borrow from a bank rather than bonds)
3) It may be harder to raise finance in times of financial distress