Reading: Understanding and Valuing Debt and Equity

Too much debt can also induce firms to stop investing, even though the investment projects at hand might be valuable. This is the so-called underinvestment problem. To illustrate, consider a very simple firm with the following characteristics:

• The firm has nominal debt of 1'000 outstanding
• It didn't do well in the past and its only asset is a cash balance of 100.

Now the firm comes across the following project:

• Invest 200 today
• Receive a guaranteed payment of 700 instantaneoulsy.

Clearly, this is a fantastic project, as it promises a net present value (NPV) of 500, without uncertainty:

NPV = -200 + 700 = 500.

In order to finance the project, the firm needs to raise additional capital of 100. Given the bad experiences from the past, there is no additional debt financing available. Will the shareholders pay in additional equity of 100?

The answer is most likely NO. The reason is that the shareholders are better off without the project:

• Without the project, the remaining cash of 100 goes to the debtholders. The payoff to the shareholders is 0.
• With the project, the shareholders invest another 100, but all the proceeds of the project (700) go to the debtholders. Consequently, the payoff to the shareholders is -100.

Rational shareholders have no incentive to do the project, even though it has a significant positive NPV.