3. Incentive Implications

3.3. Other Incentive Problems

Similar to the asset substitution and the underinvestment problem, excessive debt financing can lead to additional incentive problems:

  

Shortsighted investment problem

To secure sufficient funds to service the contractual debt payments, firms might forego attractive investment opportunities that run longer than the maturity of the outstanding debt.

  • Consider, for example, a firm that has 10 million of debt outstanding that matures in 2 years.
  • To invest this money, two projects are available
    • Project A generates a payout of 11 million in 2 years (present value)
    • Project B generates a payout of 30 million in 4 years (present value).
  • Since both payouts are expressed as a present value, it is obvious that project B is much more attractive than project A (its NPV is 19 million higher).
  • However, project B exposes the firm to a refinancing risk: In 2 years, it will have to refinance the 10 million of debt for another 2 years (until the maturity of the project).
  • For firms with excessive borrowing and limited access to capital might therefore choose project A. 

Consequently, financially constrained firms might forego the valuable long-term project (B) and instead opt for the shorter project A, which is much less valuable.

 

Reluctance to Liquidate

Finally, heavily levered firms might also be reluctant to liquidate. The reason is similar to the one behind the asset substitution problem.

If a financially troubled firm liquidates, it locks in its losses and the shareholders (usually) walk away empty-handed. By keeping the firm alive, shareholders can hold on to the outside chance of finding a project with sufficiently positive NPV so that the firm will be able to cover its financial obligations and survive.

Often, these projects might not be in the best interest of debtholders.