Debt Overhang

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21 Aug, 2024

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Debt overhang is a situation of a company where it is so overburdened with debt that it cannot borrow more money for future projects. In such a scenario, the debts of a company surpass the positive returns it could earn from a potential project. Its aim is to explain the negative impact of excessive debt on future economic growth and investment.

The debt overhang problem leads to a company not receiving funding for future projects. Banks and investors are not willing to fund the company even if the company is capable of earning profit from a new project. This is because the profit made will be used to repay the company's existing debts. As a result, the investors would suffer losses.

What Is Debt Overhang?

A debt overhang is when a company borrows more money than it can repay, leading to excessive debts.
It may not get investors to provide funding for new projects with a positive NPV that could help the company recover its losses.
The concept of debt overhang can also be applied to sovereign states, especially developing nations. This occurs when a country borrows more money than its payback capacity.
Debt overhang can result in underinvestment due to a lack of funding and restraint on issuing new stocks. It could also lead to the business making high-risk decisions, the failure of which could lead to even higher debts.

Debt Overhang Explained

Debt overhang is the scenario where a company has incurred heavy debts and cannot borrow any money to fund any future projects. The profits earned will go towards paying off the existing debts, resulting in investors not being willing to invest in such companies. Even if the company has a new project with a positive net present value or NPV, the shareholders will refuse to invest in the project as the profit earned from the new project would directly go to the debtholders. The existing debt holders would also refuse to invest more as they are already incurring losses and must be convinced that the new project will not fail.

The debt overhang problem can also apply to nations, especially developing countries. It is a condition when a country has incurred more debts than it can repay. It could lead to sluggish economic growth and a steep decline in the standard of living. Furthermore, it could affect the development of crucial infrastructure, education, and healthcare as the country could not borrow money for future investments. This situation can arise due to a lack of output growth and repeated borrowing.

The debt overhang effect impacts entities with excessive debts but is also solvent, meaning the value of their assets is higher than that of their liabilities. It also impedes an insolvent entity's ability to recover from its previously accumulated debts. Such situations result in the market value of a company's debt falling significantly shorter than its face value.

Solutions

The debt overhang effect can be solved in the following ways:

#1 - Debt Relief

In specific scenarios, the overhang can be so acute that the creditors can be in an advantageous position if they relieve the entity from paying back a portion of the outstanding debt. This step will help the management reorient the shareholders' and creditors' interests. The market value of the debt and the company's total value will rise along with the rising investments. As a result, this will ultimately benefit the creditors as the firm may revive itself and be able to pay back the remaining debts.

#2 - Declaring Bankruptcy

The insolvent companies, where the liabilities exceed the assets, cannot repay the creditors. In this case, the entity can declare itself bankrupt and free itself of all its outstanding liabilities.

#3 - Mindful Decisions About The Cash Flow

The company should be alert about controlling the cash flow. In addition, they must be very mindful of the decisions regarding how to spend the money.

Examples

Let us understand the concept with the following debt overhang examples:

Example #1

Well Built Home Ltd. is a company that makes furniture. The total value of its assets is $10 million, and the total value of its liabilities is $50 million. The company has an outstanding debt of $40 million. It got an opportunity to invest in a new project. The estimated profit to be earned from that project is $30 million.

If the firm takes up the new project, it could pay off a considerable portion of its outstanding debts. However, the investors are unwilling to fund the new project because more than the estimated profit is needed to cover the existing debts. Additionally, the odds of the company defaulting are high, leaving them at risk of incurring more losses. This is a debt overhang problem example.

Example #2

On March 16, 2023, the share prices of Emergent Biosolutions Inc. fell by 14.4% in mid-day trading. The company's guidance for the 2023 projects depicts an estimated loss ranging between $130 million and $180 million. Furthermore, the company's debt of $960 million in October 2022 is a typical debt overhang problem example.

The company is expected to end the year with a debt of $620 million. The company's share prices declined by almost 31.2% since the year's beginning and 79.1% since one year ago. The low profitability and the high debts is a scenario that indicates continued debt overhang example.

Disadvantages

The disadvantages of debt overhang have been discussed below:

The enormous amount of debt will create an impact on the spending capacity of a company. It will be unable to continue its operations at its optimum level as cutting costs will become necessary. This, in turn, will affect the production process adversely and hamper the growth of the business.
The prevailing debt will imply that the company is at risk of defaulting. As a result, the investors will not be interested in funding new projects that could help the company revive itself. In addition, the bank will not lend money, and even if they do, it will charge higher interest rates.
Equity holders would not be interested in issuing more stocks to revive the business as they will be accountable for the losses the previous equity holders suffered.
The overhang will affect business decisions. The company may either make prudent decisions to avoid further losses. Or it may take higher risks with the hope of getting higher returns. However, the high-risk choices might fail, further increasing the outstanding debts.

Frequently Asked Questions (FAQs)

How to calculate debt overhang?

Debt overhang can be calculated by finding the ratio of the value of total debts to the value of total assets. Total debt is calculated as the sum of credits, loans, long-term debts, and all other current liabilities. Total assets include inventory, equipment, cash, accounts receivable, and all other current assets.

Who propounded the debt overhang theory?

Howard propounded the debt overhang theory in the year 1972. He explained that it is a scenario where a nation's debts exceed its payback capacity. In 1977, Myers suggested that this overhang could lead to the problem of underinvestment. In 2012, Eme & Olugboyega explained that this situation occurs when the debt's estimated repayment amount surpasses the amount at which it was contracted.

Is debt overhang a moral hazard?

This situation could potentially lead to a moral hazard as businesses might take up gambling to recover the existing debts. Moreover, due to debt overhang, a company may not get investors to fund projects which could result in potential growth. Thus, the business might take up huge risks that may not serve the lender's best interests. The stakes could even lead to more losses which would increase the existing debts of the business.