Dr. P.V. Viswanath
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 d MBA 673

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# Capital Structure and Myopia

P.V. Viswanath, 2022

#### Debt and Myopia:

How can the presence of debt lead to a firm making myopic decisions?

Consider the following problem. We assume that the expected equilibrium rate of return is zero.

 Debt Due Cashflow from Existing Assets Cashflow from Short-term project Cashflow from long-term project Year 1 \$100m \$50m \$50m \$20m Year 2 \$40m \$60m in favorable state \$10m in unfavorable state \$0m \$40m

The short-term project has all of its payoffs in year 1; the long-term project has most of its payoff in year 2.  But its value exceeds that of the short-term project.

But:

If the firm selects the short-term project, it will have enough funds to meet the debt payment due in year 1.  It will default in the unfavorable state in year 2. Equityholders will get \$20 in the favorable state and zero in the unfavorable state (expected value of \$10).

If the firm selects the long-term project, it will not have enough funds and will have to refinance \$30m.  However, if the new debt is junior to the existing debt, the firm will have to promise \$50m (since it will only be able to pay \$10m in the unfavorable state). The payoffs to equityholders will be zero in the unfavorable state and \$10m in the favorable state, if it takes the long-term project (expected value of \$5). Hence equityholders will choose the short-term project.

The problem, in this case, is the need to go to the external capital markets to raise funds – which forces it to face the consequences of the potential bankruptcy in the next period. The short term project allows it to obtain the benefit of limited liability.

Exercises:

1. Construct the balance sheet of the firm as of time 1.
2. Construct the statement of cashflows for the firm at time 1.
3. Construct the statement of cashflows for the firm at time 2 under the two different possibilities:
1. if the state is favorable
2. if the state is unfavorable