Reading: Understanding and Valuing Debt and Equity

The previous pages have shown possible incentive problems that could arise if a firm has too much debt. The result of all these problems is that firms with too much debt will have a lower valuation than otherwise identical firms because they deviate from a socially optimal investment policy.

A closer look at the problems reveals that they can all be traced back to violations of some of the rather strict assumptions that we have put in place at the beginning of the capital structure discussion (the Modigliani-Miller world). In particular:

• Given investment policy
• Homogeneous expectations
• No costs of financial distress

Linking the various incentive problems to the underlying assumptions could imply:

• The asset substitution problem arises from a violation of the first assumption. Shareholders change the investment policy from low-risk to high-risk projects because of the highly levered capital policy. Consequently, the investment policy is not given, but a function of the firm's capital structure.
• The underinvestment problem would seem to be the result of a possible violation of several assumptions, including:
  • Given investment policy: Under this assumption, the new project with NPV >>> 0 would not exist to begin with.
  • Homogeneous expectations: Under this assumption, the debtholders would perfectly well understand the attractivity of the new project and consequently be willing to inject the additional capital requirements of 100.
  • No cost of financial distress: Under this assumption, the debtholders would simply take over the company and implement the attractive project themselves.
• The shortsighted investment problem as well as the reluctance to liquidate in a timely manner would seem to be the result of a possible violation of the same three assumptions.