LOAN COMMITMENTS AND THE DEBT OVERHANG PROBLEM

The debt overhang problem is shown to arise in the context of an entre preneurial project that requires a sequence of investments financed by an outside lender. The entrepreneur, not internalizing losses accruin g to the lender which financed the initial investments, may inefficien tly cancel the project and instead pursue an outside opportunity. It i s shown that loan commitments (contracts that allow the entrepreneur t o borrow a variable amount at a set interest rate in return for a fixe d fee) are the optimal financial contracts in this setting, strictly d ominating standard debt. The existence of the fixed fee allows loan co mmitments to set a relatively low interest rate, improving the entrepr eneur's incentives to continue the project. The paper specifies the op timal contract fully, derives robust comparative statics properties (u sing an extension of Milgrom and Roberts (1994)), and extends the resu lts to more realistic settings (e.g., allowing the market risk-free ra te to be stochastic).