What it means
Shareholders and lenders have different claims. Lenders are paid first and are owed a fixed amount, while shareholders receive whatever is left.
When a company is heavily indebted, any new profit may simply raise the chance that lenders are repaid, and shareholders gain little. This situation is sometimes called debt overhang, a term for existing debt that discourages new investment.
A project can have a positive net present value, meaning it creates value overall, and still be rejected by shareholders because the value mostly flows to lenders. Managers who act in the interest of shareholders then pass over good opportunities.
The problem is most severe when the firm is close to default. Shareholders in that position often prefer risky gambles, which can pay off for them while the downside falls on lenders, and they avoid safe positive-value projects that mainly protect lenders.
Economists describe these as two sides of the same conflict of interest. Lenders know this and try to protect themselves.
They may use covenants, which are contract terms that limit what the borrower can do, charge higher interest, or require security. Companies can also reduce the problem by using less debt, issuing new equity, shorter-term debt or seniority arrangements in which new lenders for the project are repaid first.
For a manager, the lesson is that capital structure affects investment decisions. A firm that borrows too much may find it cannot grow when opportunities arise.
Keeping some borrowing capacity in reserve is a practical way to avoid the problem. Boards can also design incentives with the problem in mind.
Rewarding managers only on short-term profit can encourage them to skip long-term projects, whereas linking pay to value created over several years supports investment. The aim is to make sure good projects are funded even when the balance sheet is stretched.
In practice
Real-world examples.
Example
A shipping company with heavy borrowing is offered a chance to refit vessels at a cost of $20,000,000 that will pay back well. Most of the gain would go towards repaying existing lenders, so the owners decline to put in the money, even though the refit would raise the value of the whole company.
Example
A retailer in financial difficulty has the chance to open new stores with a positive return. Shareholders refuse to fund them, but agree to proceed when a new lender provides project-specific financing that is repaid from the new stores first.
Example
A property developer with a high debt level cannot raise equity for a profitable project, so a partner with a strong balance sheet takes on the investment and shares the returns. The developer accepts a smaller share of profit in exchange for getting the project built.
Formula
Calculation
Change in shareholder value = Increase in equity value from the project - New equity invested
A company owes lenders $100,000,000 but its assets are worth only $80,000,000, so the equity is worth nothing. A new project costs $10,000,000, to be paid by shareholders, and will add $12,000,000 to the value of the company, a positive net present value of 12,000,000 - 10,000,000 = $2,000,000. After the project the assets are worth 80,000,000 + 12,000,000 = $92,000,000, still less than the debt of $100,000,000, so the equity stays at zero. The change in shareholder value is 0 - 10,000,000 = -$10,000,000, so shareholders reject a project that adds $2,000,000 of overall value.Case study
Seen in the real world.
Brackenridge Airlines is an illustrative, fictional carrier that borrowed heavily to expand its fleet. When demand slowed, the company's debts were close to the value of its assets, and the owners were reluctant to commit more money.
The finance team identified a $15,000,000 investment in fuel-saving engines with an estimated net present value of $3,000,000. The shareholders refused to fund it because the savings would mainly strengthen the lenders' position, even though the project was clearly valuable.
The illustrative solution was to ask the main lender to provide a separate equipment loan secured on the new engines. The lender agreed because it would be repaid first from the savings, the project went ahead, and the airline's costs fell over the following years. The lender's willingness to fund the engines showed how a change in structure can remove the conflict.
Watch out
Common mistakes.
- Assuming that every positive net present value project will be accepted, when heavily indebted owners may refuse it.
- Blaming management skill, when the cause is often the structure of debt and equity claims.
- Adding more debt to fund investments, which can make the problem worse by increasing the overhang.
Questions
People also ask.
Is the underinvestment problem the same as debt overhang?
They are closely related, and the second term describes the existing debt that causes the first problem.
How do lenders reduce the problem?
They can use covenants, secured project loans, shorter maturities or priority repayment for new funding.
Can issuing equity solve it?
It can help, because new equity reduces debt relative to value, but existing shareholders may resist if the new money benefits lenders.
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