Debt Overhang

Add-On Interest

What is over-indebtedness?

Over-indebtedness refers to such a large debt burden that an entity cannot take on additional debt to finance future projects. This includes entities profitable enough to be able to reduce debt over time. Excess debt is used to deter current investment, as all benefits from new projects would go only to existing debt holders, leaving little incentive and capacity for the entity to try to get out of the hole.

Key points to remember

  • Over-indebtedness refers to such a large debt burden that an entity cannot take on additional debt to finance future projects.
  • The burden is so great that all of the income pays off the existing debt rather than funding new investment projects, which increases the risk of default.
  • Over-indebtedness can lead to underinvestment, which slows growth, making recovery even more difficult.

Understanding over-indebtedness

When an entity has an excessive amount of debt and cannot borrow more capital, that entity is deemed to be in debt. The burden is so great that all the income goes directly to paying off the existing debt rather than funding new investment projects, thereby increasing the risk of default. In most cases, shareholders may be reluctant to approve new share issues because the shareholders are likely to suffer losses.

Surplus debt also applies to sovereign governments. In these cases, the term refers to a situation in which a nation’s debt exceeds its future ability to repay it. This may be due to a production gap or to economic underemployment, which is repeatedly blocked by the creation of additional credits. Excess debt can lead to stagnant growth and a deterioration in living standards, from reducing funds to spending in critical areas such as health care, education and infrastructure.

Because of the way they affect balance sheets and results, over-indebtedness can disrupt entities in different ways. They can lead companies and countries to suspend new spending and / or investment. In fact, they can lead to underinvestment. Because they can dampen growth, over-indebtedness can make recovery even more difficult.

There are many ways to get out of debt distress. Debtors can sign up for debt cancellation programs to get some or all of their debts canceled by creditors, countries can default on their debt, businesses can become insolvent or bankrupt, or debt existing can be bought back and converted into equity.

The risk of default on debt is greater when a company or a country has excess debt.

Special considerations

Excess debt can trap businesses because more of the revenue or cash flow is simply used to service existing debt. This widening of the deficit can only be covered by additional debt, which only increases the burden on a business.

Over-indebtedness is particularly difficult because it blocks companies looking to take advantage of new opportunities with positive net present value (NPV). Although under more normal conditions, these potential projects would pay off over time, an increase in existing debt in a business could likely deter potential investors in the project. Since the company’s creditors can reasonably be expected to claim some or all of the profits from the new project, the NPV would actually be negative.

To resolve the over-indebtedness of many developing countries, debt cancellation programs are sometimes implemented by intergovernmental organizations such as the World Bank and international organizations such as the International Monetary Fund (IMF). The programs covered Côte d’Ivoire, the Democratic Republic of the Congo, Gabon, Namibia, Nigeria, Rwanda, Senegal and Zambia. Another program, the Jubilee 2000 campaign, was an international movement of 40 countries, which called for debt cancellation for developing countries by the year 2000. Although the campaign had not reached its full potential goals, it was welcomed and was generally considered successful.

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