Question

Consider the debt overhang. The analysis studied the possibility of financing a new project with new equity issuance. Does the same conclusion hold in case the new project is financed by debt issuance? Consider two cases.

a. The newly issued debt has the same level of seniority of existing debt, that is, any cashflows are equally shared among old debtholders and new debtholders.

b. The newly issued debt is junior to existing debt, that is, old debtholders must be paid in full before new debtholders get anything.

c. Compare a) and b). What does this example tell you about the importance of seniority clauses in debt covenants?

Answer 1

As we compare parts A and B we see the difference in the form of seniority of debt. The older debt holders should be given a preferential position over the new debt holders. This is because they had taken the risk of investing in the business earlier than the newer ones. Also the older borrowings must be discharged first before the new debt is paid off.

Hence the debt covenants must specifically mention the seniority clauses to ensure that they are not treated at par with the new borrowings of the business and they should be given a preferential treatment as far as repayment is concerned.