- Define debt overhang. Explain why debt overhang can reduce firm value.
Ans: Debt overhang refers to the phenomenon of existing debt preventing the firm from raising new funding. This usually occurs because the value generated from the new project goes first to the existing debtholders and not enough is left over to compensate the new lenders. When there is a new investment that is potentially profitable for which the firm cannot raise funds, potential value is lost.
- Define credit rationing. Explain why credit rationing occurs.
Ans: Credit rationing occurs when a firm cannot obtain funds at any interest rate. Lenders may not be willing to provide a firm with financing because its cashflows are volatile and default probability is high. However, an increased interest rate cannot compensate for the risk because raising the interest rate increases the incentive for the firm to take more risks. This can lead to a vicious cycle, where no amount of promised compensation will make the loan profitable.