Week 2 - Debt Overhang

Question 1

What is Debt Overhang?

Answer 1

Some of the cash flows from a new investment accrue to the existing debt holders. their debt gets less risky and is therefore worth more
- Existing debt holders did not contribute to the investment
- This transfer of wealth to existing debt holders discourages investment by shareholders

Question 2

Does debt overhang exist without risky debt?

Answer 2

No
- All equity firm reaps the entire NPV of new project and so undertakes all positive NPV projects

Question 3

Problem with debt overhang

Answer 3

• too much debt reduces the value of the firm because of debt overhang
• Problem would not arise with only safe debt
• Safe debt gets repaid anyway, so it does not profit from the cash flows generated by the new investment

Question 4

How does debt overhang lead to underinvestment

Answer 4

• The entrepreneur incurs the entire NPV cost but only gets part of the return
• Holders of the existing risky debt do not contribute to the funding but their claim becomes less risky and therefore more valuable
• This windfall to debtholders can prevent optimal investment policy
• because of debt overhang the firm may not undertake positive NPV projects that would increase firm value

Question 5

Debt overhang observations

Answer 5

• Debt overhang can only materialize if debt is risky -> with risk-free debt, there is no transfer and hence no distortion in the investment decision
• Crucial that cash flows from the new investment cannot be contracted upon seperately from that of the assets in place -> project can be undertaken in a separate entity with no existing debt holders - this is called project finance

Question 6

How does external financing impact debt overhang?

Answer 6

Nothing changes -> With competitive capital markets, Entrepreneur needs to promise new investors a repayment with present value of the investment amount I

Decision problem is unchanged - investment only takes place if: project NPV > transfer to existing debt holders

Question 7

Can renegotiation of debt help?

Answer 7

Yes

Intuition: Debtholder’s expected payoff is unchanged, Entrepreneur recieves the investment’s entire NPV which is positive so Entrepreneur is happy to invest.

Question 8

Debt Renegotiation Remark 1

Answer 8

Remark 1:

• Reasoning does not rely on E receiving the entire surplus
• How the surplus is shared depends on the parties’ bargaining position. Transfer to debt holders is reduced so that the shareholder is willing to invest.

Question 9

Debt Renegotiation Remark 2