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If a firm increases its debt to a very high level, then the positive impact of...

If a firm increases its debt to a very high level, then the positive impact of debt in aligning the interests of management with those of stockholders tends to become negative. Explain why this occurs.

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Expert Solution

Debt Overhang or Debt Burden is a situation or stress on the overall Balance Sheet of the Company. This is a stiuation where the company reaches its maximum Borrowing power and the quantum is so large that the servicing the debt could be an issue. This is a situation where the net profits/returns of the company or project are either completely consumed or insufficient to support the cost of debt. Also, this is a situation where the free cash flows generated from the operations of the company are not capable to service the debt instalments. If this situation is not monitored in the early stage, it can trap the company in to default state and can completely pull down the financial strength / creditworthiness of the company.

This is a situation where the debt capacity, rather than supporting the operations of the company, starts conmuing the profits from the operations, in the form of cost of debt; This results in the negative impact on the overall financials of the company and thus results in the decline in the retained earnings or dividend payout capacity to the shareholders.

This is the reason why any entity has to carefully choose their financial options between Equity and Debt modes, based on the requirements, strengths and weaknesses.

jeff jeffy answered 2 years ago
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