Debt Holder – Equity Holder Conflicts and Corporate Finance.ppt

Financially distressed firms: firms with high debt but is not in bankrupt. Financially distressed firms tend to engage in actions that are harmful to, Debt holders Risk shifting in the previous chapter. Nonfinancial stakeholders The project will not be undertaken in the unfavorable state. Rational debt holders can expect this at the first period and require a face value F 100. In this case at favorable state the cost of risky debt is too high (leverage is 1) and the NPV is too small. The new debt holders are not able to obtain equilibrium return so they do not provide credit. Show free rider problem, 100 debt holders. What is the best method to alleviate the debt overhang problem? Do not use debt. An all equity firm will use internal cash to finance this project. There is no conflicts of interest. A word promise to commit to process 1 is incredible. When debt level is high the conflict between shareholders and debt holders is severe. When the credit condition tightens creditors are suppose to require higher interest rate for providing debt financing to firms. But often time we observe that when the credit condition tightens many banks ration their credit. When interest rate is higher, the debt obligation becomes higher. The incentive of asset substitution is more obvious. Shareholders are reluctant to liquidate and debt holders want to liquidate immediately. But when there are more than one debt holders (senior debt holders and junior debt holders) the situation becomes complicated. Not all debt holders want to liquidate immediately. Junior debt holders may be reluctant to liquidate either because they have similar option-like payoffs. In many cases it may be in the interest of junior creditors to lend additional money to a firm in financial distress to keep it from going bankrupt even if the liquidation value is higher than going concern value. The new loan itself is not a good investment, it creates value for the existing debt by continuing a out-of-money call