It is time that countries learn what firms knew all along—that bad fiscal management, most especially excessive debt, is detrimental to growth and long-term survival. Debt overhang leads to lower growth and inefficient allocations and decisions for a myriad of reasons. Cautionary parallels can be drawn between firm and sovereign financial distress.
Like firms, countries that are deep in debt may be unable to borrow money to finance promising new industrial development projects because any profits may have to be paid first to existing lenders. Paul Krugman has stated that “a debtor country is like a debtor firm where creditors view the firm as having a stream of future revenues out of which debt service can be paid. ... We can think of the expected stream of potential resource transfers from a country to its creditors as analogous to the expected stream of earnings from a firm… [and] a country has a debt overhang problem when the expected present value of potential future resource transfers is less than its debt.”
One of the main problems with debt overhang is that existing debt deters new investment because the benefits from new investment go to the existing creditors rather than to new investors. Debt overhang creates a threshold value for investment returns; below it, the firm cannot attract funds, and thus cannot invest. As a result, many otherwise profitable investments will be turned down. This can have the effect of stunting economic growth and, in the aggregate, making national economies more vulnerable to recession. Economist Owen Lamont argues that debt overhang can crowd out productive investment because all revenue must first go towards paying the debt service. National investment can suffer as countries must first service their debt load.
In contrast with standard free-cash-flow explanations, where the discipliner (at least implicitly) has more power ex ante than ex post, the pressure on management to commit voluntarily to debt is derived from the constant presence of a potential discipliner. In particular, a sufficiently high level of anticipated future inefficiency is presumed necessary for a takeover. Debt-constrained managers do not refrain from bad projects because they lack cash on hand to start up such projects, but rather because allocating limited cash flow to these projects increases the chance of future bankruptcy.
Like firms, countries that are highly indebted may be unable to borrow money to finance promising new industrial development projects because any profits may have to be paid first to existing lenders. This situation is inefficient, because value is lost from the underinvestment caused by debt overhang. This is illustrated in the following example:
Suppose a firm has an outstanding debt of $10 million more than the value of its assets and that it then obtains an opportunity to make an investment of $5 million yielding a sure gross return of $12 million for a guaranteed net profit of $7 million. If the debt covenants give the current debt priority for repayment, then no new lender or investor will be willing to finance the investment because the first $10 million accrues to holders of its existing debt, leaving only $2 million in returns for the $5 million of new investment. As a result, the profitable investment may not be undertaken and value may be lost.
Similarly, there is the problem of the cost of capital. Piling up more debt benefits shareholders only up to a point. That point, roughly speaking, is reached when bondholders are so worried about the company defaulting that the cost of its debt rises to unsustainable levels. To go on borrowing beyond that point may even lead to bankruptcy.
Let’s compare the difference between managers’ incentives to undertake one investment project in two different capital structures of the firm. The first case describes an all-equity financed firm; the second portrays a firm with a debt-equity capital structure. In both cases, the model assumes that managers and shareholders share the same information, managers act in the shareholders’ interests, there are no taxes or bankruptcy costs, and capital markets are perfect and complete.
Model 1: All-equity financed firm
A firm’s market share (V) is determined by two different types of assets, the value of assets already in place (Va) and the present value of assets coming from the realization of future growth opportunities (Vg), such that V = Va + Vg. Without loss of generality, the firm in this case is assumed to have no assets in place. Ex ante, its market value is determined by the present value of all the investment options available to it. The model also assumes that there is just one year of investment that requires a disbursement of I at t = 0. In an all-equity scenario, if the firm decides to undertake the investment, new equity is issued to finance its cost. The revenue generated by the project at t=1 is given by V(s). If, alternatively, the firm decides not to exercise the investment option, no more shares are issued and the firm is worth nothing.
The investment should be undertaken if V(s) >= I which means that the Net Present Value (NPV) of the project should be greater than or equal to zero. Therefore, the firm would not invest in projects that generate a value of V lower than I. Figure 1 below shows this investment strategy. In those situations to the left of S* are economically unfavorable; the firm does not invest when they occur. The situations to the right of S* reflect profitable investment options, and consequently, the firm exercises the investment. The difference between the line V(s) and I indicates the net profit level as a function of S.
Model 2: Debt-equity financed firm
Instead, assume that initially the firm has a debt-equity capital structure. The outstanding debt, promised to be paid within a year, has a face value of Vd and the value of equity is Ve. In this case, the firm issues new debt to finance the potential investment project. However, this debt is risky since there are states to the left of S* where the firm is worth nothing. The relevance of pre-existing debt occurs when the firm is expected to pay it back and the investment decision has been made. It is profitable to undertake the investment option as long as V(s) – Vd – I> 0 or V(s) > [Vd + I]. If V(s) < Vd + I and the project is taken, the incurred spending would be larger than the market value of the shareholders and they would lose.
Figure 2 shows the investment strategy of managers in the presence of debt in the capital structure of the firm. Instead of having S* as a decision point, S** is now the threshold that makes V(S**) equal to Vd + I. Potential investment projects between S* and S** are neglected positive investment opportunities. The net loss is indicated by triangle L. Figure 2 shows as debt increases, a greater number of positive net present value projects cannot be undertaken.
A debt-equity firm with outstanding risky debt will follow a different investment decision rule than the one corresponding to a firm that does not issue risky debt or has no debt at all. Managers of a debt-equity firm (with value less than an equivalent all-equity financed firm) will demand a return on investments high enough to cover at least the investment cost and the corresponding payment owed to debt holders. Thus, some investment projects that exhibit a positive net present value but do not satisfy the above conditions are neglected, resulting in a suboptimal investment policy.
David J. Lynn, Ph.D., is chief investment strategist with Cole Real Estate Investments and is based in New York City.