Explanation of Debt Overhang

Debt overhang is a term to describe either a company or a whole economy that is in too much debt to be profitable in the future. Mathematically speaking, the current existing debt is greater than the net present value of any future asset and its profits. As a result, investors in the new projects would not generate healthy returns even if the projects were successful. This renders investors unwilling to purchase new stock, and existing investors may not receive dividends and payment on the stock they currently hold. 

Debt Overhang Example

John operates a small lemonade stand which cost him $200 in lumber to build. He borrowed this money from his grandfather and gave him a 50 percent stake in the company as a result. He now needs to buy lemonade, and he asks his grandmother for $20 to do so. John promises his grandmother he will repay her with 20 percent of the profits, and he even shows her a projection that estimates the lemonade stand will earn $150 today.

Under normal circumstances, grandmother may extend the loan thinking she could earn an easy $10 - $30 in profits from the lemonade stand minus the $20 she loaned. However, grandmother sees that John must first repay grandfather $75, and this will render him less profitable, which means she will not make back her investment. John's debt overhang is too great to entice grandmother as an investor.

National Debt Overhang

Debt overhang was a term used strictly in the private sector when it was created. However, the national vocabulary began to use a different interpretation of the term in the late 1980s. At that time, the Federal Deficit was growing. Economists theorized this deficit would be repaid with increased taxes in the future. Therefore, they were wary of investing large sums of money into new business developments. They feared any profits would be taxed away by the government in the long-term. While this is a very strong model, weaker models indicate that lenders and investors are less likely to extend money into the economy when national debt is high. They fear returns will not keep pace with increasing taxes. 

Debt Overhang Solution

For either a company or a government, debt overhang makes it impossible to achieve new financing. To overcome this problem, some existing debt must be repurchased and turned into equity. In the example above, John could pay his grandfather back prior to seeking a loan from his grandmother. The $200 of debt he once had has now been turned into $200 of equity in the lemonade stand.

Grandmother may accept this as collateral on an even larger loan. This is called a debt for equity swap. It can happen at the private level or with a national government. With a national government, the law makers must decide to reduce deficit by cutting spending or raising taxes in the short-term. In the long-term, the effect of these changes will be a lower deficit, which will lead to lower debt overhang.

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