Debt Overhang: I
Consider a firm with $4000 of principal and interest payments due at the end of the year (assume $3500 lent at 14.29% stated).  If there is a recession, it will be pulled into bankruptcy because its cash flows will be only $2400.  Else, it will have cash flows of $5000.
The firm could avoid bankruptcy in a recession by raising new equity to invest in a new project (soon after beginning).  The project costs $1000 and brings in $1700 in either state and has an NPV > 0.
Recession and Boom states are equally likely.
Will it do the right thing and raise new equity funds?

Debt Overhang: II

Debt Overhang: III
Bondholders’ return = -8.57%; exp. equity payoff = $500; total return = 7.14%. Bond buyers will have to demand higher yields to account for the possibility that stockholders will turn down desirable projects in the future. This might make initial project unprofitable as well; need 31.43% stated return on bonds and only $200 for stockholders to obtain even 0% return for bondholders.

Debt Overhang: IV
Assets in place with new project would yield (6700+4100)/2 = 5400 on a total investment of 4500 for a return of 20%; return to bondholders would be 14.29%, but stockholders won’t go for this.

Debt Overhang: Senior Debt
One Solution:
If the new project could be financed  separately, say, under debtor-in-possession financing, or a new issue  that would be senior to the previous issue, then (assuming a riskfree rate of 10%), the new project would be undertaken; and bondholders would be better off.

Debt Overhang: Loan Commitments
Another solution:  Two stage financing structured as a loan commitment.  Suppose the fee equals $600 plus 10% of draw-down.  Return for bondholders (w/proj) = [(5550+4100) /2] /4500 = 7.3%

Debt Overhang: Loan Commitments