6. Understanding and Valuing Debt and Equity

The preceding sections have looked in great detail at the tax implications of financing decisions. In what follows, we focus on other "side-effects" of financing decisions and show that these other side-effects might often be at least as relevant than the direct tax implications. The purpose of this section is to take a closer look at the incentive and valuation implications of debt financing.

To better understand how debt financing affects the incentives of the involved parties, it makes sense to compare the key characteristics of the payoffs to debt and equity. This is how we start. One of the most direct implications is that debtholders are risk averse whereas (high) leverage gives shareholders an incentive to increase the riskiness of the firm. In the extreme, shareholders are better off when the firm pursues a high-risk project that distroys value, on average. This is the so-called asset substitution problem. We consider other typical incentive problems that (too much) debt can bring about, including the reluctance to invest (underinvestment problem) or the preference for short-term projects, and we discuss how debt contracts typically try to address these problems.

Understanding the payoffs to debt and equity is also helpful for the valuation of these claim. In the second part of this section, we introduce the so-called Merton model, which decomposes the overall value of the firm into a debt value and an equity value using option pricing. A valuable side effect of this model is that it allows us to estimate the market-implied probability of default as well as the expected loss in default, among other things.