The Underinvestment Problem: One Solution:
Suppose we were to restructure the bond by including a
covenant that limited the amount of dividends that the firm could pay in
any period to 50. What effect would adding that covenant have on shareholders'
incentives?
| Project |
0 |
1 |
2 |
NPV |
|
A |
-50 |
100 |
50 |
100 |
|
B |
-75 |
100 |
25 |
|
|
Bond |
120 |
-20 |
-100 |
|
|
Div(A+B) |
||||
|
Div(A) |
What will the shareholders do?
What rate of return will bondholders realize?
What will be the value of the firm?
How does the firm in this case compare to the firm value
when the firm was all equity financed?
Who benefited from the dividend covenant?
What's going on here?