Wealth Expropriation Example:

Example of the “Myers Under-Investment Problem” , AKA the Debt-

Overhang Problem

Basic Set up: HM Company (HMC)

• There are two equally likely outcomes (payoffs)
• All securities (assets) are valued at their expected values (no
interest, no risk problems)

• HMC has assets that produce payoffs of either $1.4B or $8B

• HMC has debt with $2B FACE Value (promised repayment)

 initial values of assets, debt and equity are (fill in table on next slide)?
 The Debt-Overhang Problem

HM Company (HMC)
• HMC has assets that produce payoffs of either $1.4B or $8B
 asset value is 1.4/2 + 8/2 = 4.7B
• HMC has debt with $2B FACE Value (promised repayment)
 initial values of debt = 1.7B
 Initial value of equity = 3B

Assets = 1.4 Assets = 8

Bad state Good state
prob = .5 prob = .5
4.7
Assets 1.4 8 expected value = B
1.7
Debt 1.4 2 expected value = B
3.0
Now,Equity
consider a $.5B
0 investment
6 inexpected
buildingvalue
maintenance
= B that
increases the future value of assets by $.6B, in each state

What is the NPV of this investment project? NPV = -0.5B + 0.6B = 0.1B
 With the investment in maintenance,
financed by issuing $.5B of new equity

The payoffs become:

HMC: prob = .5 prob = .5

Assets 1.4 + 0.6 = 2 8 + 0.6 = 8.6 expected value = 5.3

Debt 2 2 expected value = 2

New equity 0 1 expected value = 0.5 (given)

Old equity 0 5.6 (residual) expected value = 2.8

 Firm value increases by… 5.3 – 4.7 = 0.6M

 Debt value increases by… 2 – 1.7 = 0.3M
 New equity increases by... 0.5M (given)

 Original equity value… decreases by 0.2 (2.8 – 3)

 Debt holders get all the benefit so shareholders don’t want to

undertake this project; Debt holders get $0.3B benefit; existing
shareholders lose $0.2B => Underinvestment problem
 Suppose the $.5B is raised by issuing junior debt

The payoffs become:

HMC: prob = .5 prob = .5

Assets 2 8.6 expected value 5.3

Old Debt 2 2 expected value 2

New Debt 0 1 expected value 0.5 (given)

Equity 0 5.6 expected value 2.8

 Firm value increases by… 5.3 – 4.7 = 0.6M

 Old Debt increases in value by… 2 – 1.7 = 0.3M
 New debt increases by.. 0.5
 Original equity decreases in value by… 2.8 – 3 = 0.2M

 Shareholders prefer to: pass

 Same problem as in the previous slide
 Suppose the $.5B is raised by issuing senior debt
Payoffs:
HMC: prob = .5 prob = .5

Assets 2 8.6 expected value 5.3

1.5
Old Debt (residual) 2 expected value 1.75

New Debt 0.5 0.5 expected value 0.5 (given)

Equity 0 6.1 expected value 3.05

 The shareholders prefer to:

 Undertake the project  0.1B NPV is split evenly between the existing
shareholders & bondholders
 Project increases the shareholder wealth by 3.05 – 3.0 = 0.5B

 What does this suggest about the robustness of the underinvestment

problem?
 Firms can’t issue senior debt because the old debt would not get paid
in full (in the first scenario, with assets valued at 2; old debt only paid
at 1.5)
 Debt Overhang: Conclusion

 Firms may face subtly distorted investment

incentives that are related to capital structure.

 The debt overhand problem is mitigated when

debt is less risky and completely alleviated if
debt is riskless.

 = (Myers underinvestment incentive)

 Suppose the $.5B is raised by
issuing pari-passu (equal priority) debt
HMC: prob = .5 prob = .5

Assets 2 8.6 expected value 5.3

Old Debt 2/(2+x) 2 expected value 1.78

0.5
New Debt x/(2+x) X expected value (given)

Equity expected value 3.02

In this case, it’s harder to determine the face value that makes the new debt worth $5B
 In the bad state, the liquidation value is distributed proportionately to debt holders,
based on face values

 Let x be the face value of the new debt, so the new debt gets the proportion x/(2+x)
of the $2B, and the old debt gets the proportion 2/(2+x).
 2/(2+x) + x/(2+x) = 0.5 =>Solve for x

 For the new debt to be priced at $.5B, we need ?

 Solve using formula for quadratic  x = $?
 X = 0.56
 After issuing the new debt and making the investment, shareholders will prefer to
accept the project. Shareholder value will be 3.02B, which is higher by 0.2B
 Agency problems
 Asset substitution effect: management has an increased incentive to
undertake risky, negative NPV projects – Shareholders get bigger
return while debt-holders have the risk of not getting paid in full
(overinvesting in risk)

 Underinvestment problem (Debt overhang problem): If debt is risky

(e.g. growth company), the gain from the project will go to debtholders
rather than shareholders b/c shareholders might not get paid.
Management have an incentive to reject positive NPV projects b/c of
shareholders.

 Free cash flow: unless FCF is given back to investors, management

has an incentive to destroy firm value through empire building, perks,
etc.