Dr. P.V. Viswanath
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.
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.
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.