Question

1. Express the position of a debt holder in terms of put options.
2. Build your answers on part (a) of this question, use option theory to explain the debt-overhang problem, or, how managers could decide to forgo projects with positive NPVs when the firm has a high level of financial leverage. (Word limit: 100)

Answer 1

a) Put option means right to sale, So it gives the right to debt holder to exercise the option & receive the amount against the put irrespective of the value of the firm i.e. It helps the debt holder to cover its risk . for example If the firm goes bank corrupt & asset value of the firm is less than debt amount then by exercising put option debt holder can receive its entire amount against the debt.So by having put option debt holder can receive difference between debt amount & asset value of the firm.

b) Debt overhang refers to the position that debt position so large that entity cannot take further debt.It happens when company had taken huge debts & that result in all the earning of the company or substantial part of the earning of the company goes to repay the existing debt rather than funding the new project. In this scenario, Some times manager had to forgo projects with positive NPV's also because to invest in the project , manager need to raise the money &Equity holder is reluctant to invest in the company as they are already on the hook of losses and to raise the debt will increase the burden further more. Due to this issue firm gooes into trap and it will lead to under investment & less profitability which will make it hard for the firm to repay its debt & solve this problem.

In the Scenario of debt overhang, debt holder might go for Put option, as it would help him to get its entire payment in case firm asset not able to pay the debt amount.