Underinvestment (Debt overhang)

hei , talking about the financial distress one of the selfish strategies shareholders use is debt overhang … i really dont have a clear picture of it can u guys please explain with some practical example , secondly how the use of bank debt can be protective against it … (like for asset substitution , it can be protected by facilitating lender’s monitoring and enforcement of protective covenants) thankyou

Debt overhang can lead to underinvestment due to a firm’s attempt to cut costs in order to stay current on debt service payments. The cost cutting actions that are taken adversely impact the profitability of the firm in turn making the problem worse. Example: A firm cuts costs by firing half its sales force without action in place to pick up the void of less sales volume. Although an operating expense has been reduced so has the profitably of the firm (perhaps even more so then the savings, thing undoing the benefits of economies of scale)… now the following period the firm is still struggling to meet debt service and running out of options. hope this helps, it was the best example i could come up with on the fly.

I’m not sure that debt overhang is a selfish strategy used by stockholders, but just an inherent conflict between stockholders and bondholders. First, debt overhang is just a situation in which future cashflows can’t service the debt. It’s obviously a situation everyone wants to avoid. But s%^t happens and then there’s a conflict. For example, we have a two-stage investment opportunity that requires $100 at start-up and then $100 at some later time. The investment will return either $600 or $150. Debtholders fund the original investment and have first dibs on cash-flow (i.e. are senior to everyone else). At later time the world has gone to heck and it’s clear that the investment is only going to return $150 if it’s funded up. Now we have debt overhang because we need to borrow an additional $100 for a project that now has a positive NPV (100 -> 150) but all of that just accrues to cutting the original lender’s losses and none of it accrues to the stockholders. Further, there is no chance that anyone else is going to lend you $100 because they would be junior to the people who provided the original financing. A stockholder would likely say, oh well, you senior guys take the $100 hit and we’re done with this, even though the project would otherwise be profitable in some macro sense.