【正文】 Lily Pharmaceuticals Research ?The research project ? Lily Pharmaceuticals Research recently spent $100 million to undertake research on a new drug. We assume that with probability 10/11 the market for this drug is favorable in the next year. In this case, the firm can spend an additional $100 million in year 1 to further develop the drug, bring it to market and sell the marketing rights to the drug for $500 million in year 2. If the market is unfavorable, the pany will have a drug with marketing rights worth $150 million in year 2 provided that it spends the additional $100 million for development in year1. Lily Pharmaceuticals Research ?The financing ? To finance the initial $100 million, Lily issued a bond with a covenant specifying that any additional debt the firm issues must have lower priority in the event of bankruptcy. We assume the investors are risk neutral and that the appropriate expected rate of return on bonds is zero. We will show later the firm will default on this obligation and pay nothing when the market is unfavorable with probability 1/11. therefore to raise the $100 million, Lily must promise to pay $110 million in the future to pensate the investors for the possibility that they may not be paid. The Diagram Market looks favorable Market looks unfavorable Spend $100 million in development costs to continue Sell marketing rights worth $500 million Sell marketing rights worth $150 million Borrow $100 million to fund original research, Lily issue a bond with face value F 10/11 1/11 ? In the unfavorable situation, continuing with the project is still a positive NPV investment with NPV = $150 – $100 = $50 million. ? The continuation will not be financed, ? Existing debt is more senior and will be paid prior to the new debt. The profit from undertaking the project $50 is not enough to pay back the existing debt (F 100). Financing the project is a negative NPV project from the perspective of new creditors. They are not willing to provide additional debt. ? The firm is not able to borrow to undertake the positive NPV project in the unfavorable situation and will default in this situation, F*10/11 + 0*1/11 = 100 F = 110 Underinvestment and the Free Rider Problem ? The Lily will be better off if it is possible for the firm to renegotiate new debt with the original debt holders, ? If the original debt holders do not provide new funding they will lose the $100 million initial investment in the unfavorable state. ? By financing the positive NPV project in the unfavorable situation the original debt holders will lose only $50 million in the unfavorable state. ? If the original bonds are held by a diffuse group of lenders, it will be difficult to persuade them to finance the project because for each individual debt holder the best strategy is to free ride. ? Individual debt holder who does not provide additional debt also enjoys the value increase in the existing senior debt if the other debt holders lend new debt. ? Private debt as a mechanism to mitigate the debt overhang problem is better than public debt. Seniority Structure and Debt Overhang ? If the existing debt is unprotected, Lily can issue additional $100 million senior debt at a risk free rate to finance the project in the unfavorable situation. ? This leaves $50 million to the existing debt holders. ? An unprotected existing debt can solve the debt overhang problem. But the original debt holders may not be willing to issue unprotected debt at the beginning because its value could be easily expropriated by shareholders. ? With unprotected debt, shareholders can simply issue additional senior debt to divert the value of existing unprotected debt. Dividend Policy and Debt Overhang ? If the firm has $100 million internal cash, will the shareholders invest to continue in the unfavorable situation? ? The answer is no, ? If the shareholders invest $100 million they will lose $50 million. The investment on riskless project increases the value of existing debt at the expense of shareholders. ? If the shareholders do not invest and spend the $100 million cash to pay back the existing debt, they will lose $100 million. It is equivalent to secure the existing debt using their own money. ? The shareholders will prefer to distribute the $100 million cash as dividend and then default on the existing debt. ? With risky debt, equity holders have an incentive to pass up internally financed positive NPV projects and pay out cash as dividend. The Shortsighted Investment Problem ?Future debt obligations can make firms shortsighted: ? Debt can lead firms to favor lower NPV investment projects that pay off quickly over higher NPV projects with lower initial cash flows. ?The intuition is rooted in the debt overhang problem, ? Firms with large debt obligations need to pay high borrowing rates on new subordinated debt used to refinance the portion of their existing debt that is maturing in the short run. Firms have an incentive to generate cash quickly to minimize the amount of debt they need to refinance at high rate. The Case of Applied Textronics ? Applied Textronics has a debt obligation of $100 million due next year and $40 million due the following year. The firm is considering two equally costly mutually exclusive projects: ? A shortterm project that generates $50 million cash flows at year 1 and zero at year 2. ? A longterm project with $20 million at year 1 and $40 million at year 2. ? The cash flows from both short – term and long – term projects are certain. We further assume neutrality and zero risk free rate. ? The existing assets generate $50 million positive cash flow at year 1. But the year 2 cash flow from existing assets is risky. It will be $60 million if economy is good, and $