3. Incentive Implications

Let's start by looking at how debt financing could affect the incentives and the behavior of the involved parties. To do so, we keep working with the simple firm from before. In what follows, we show that the divergent incentives of debt and equityholders can lead to costly conflicts of interest. In particular, we will see how debt can induce firms to:

  • take on unprofitable risky projects (asset substitution)
  • forego attractive investment projects (underinvestment)
  • pass up positive NPV projects for projects with a lower NPV (shortsighted investment)
  • avoid liquidation even if doing so would be better (reluctance to liquidate).

 

The following pages look at these issues in greater detail and then show ways how borrowers and lenders try to mitigate them.