Understanding the debt overhang, the negative effect of debt on corporate investment

The concept of debt overhang appeared in 1977 (1) , and is very interesting today since the corporate debt ratio will be very high once the coronavirus crisis is over. Why does a highly indebted company reduce its investment? If it has profitable investment projects, it should carry them out even if it is already indebted. A first explanation is that there is a financial imperfection: the highly indebted company cannot raise funds to invest even if this investment is very efficient; lenders or capital providers may fear the high risk of a default by this already indebted company, for example in the event of a recession in the future; The second explanation is more sophisticated: if a highly indebted company carries out a profitable investment project, the income from this investment primarily goes to the debt holders (since it enables the company to service its debt). The company’s shareholders therefore have no interest in making this investment. S.C. Myers (1977) “Determinants of Corporate Borrowing” Journal of Financial Economic, vol. 5