 In continuation, our discussion on exploiting the debt holders while taking the advantage of leverage, let's see how debt overhang problem can be estimated and what are the leverage-raget effect. How much leverage must a firm have is a significant debt overhang problem. There is an approximation rule to measure this problem of debt overhang. This rule says that the equity holder will benefit from the new investment opportunities only. If the project's profitability index is exceeding the relative riskiness of the firm's debt times its debt-equity ratio and for a firm who has zero debt or a risk-free debt, the net present value will be greater than zero. And for the risky debt in that particular firm, the required cut-off is positive at it will be increased with the increasing level of leverage. We have an example to compute debt overhang. We have two companies here and we have their respective values of their equity betas, debt betas and debt-equity ratios. Requirement is there to determine minimum NPV such that new $100,000 investment will benefit shareholders and which firm has the more severe debt overhang problem. And for this, we need to determine the cut-off level of profitability index and that comes to 0.0375 which means that there should be at least NPV of $3750 that can benefit shareholders. And so far as the cut-off level of profitability index of tax is concerned, it is 0.1675 so there is a severe debt overhang problem because its shareholders will reject all the projects that have even positive NPVs up to this higher cut-off rate. The shareholders can benefit only if this firm cashed out by liquidating its assets up to $116,750 in order to pay an additional amount of $100,000 in dividend to its stock holders. So how agency cost can affect the value of leverage? We see that owners and managers may be induced to increase leverage even the firm's value is declined. Similarly, the equity holders benefit at the expense of the debt holders in that particular case. With financial distress cost, we see that shareholders finally bear these agency costs because the debt holders recognizing this particular problem pay less amount initially to the firm when the firm is going to issue debt. So this reduces the distribution available to the shareholders in the form of dividend. The net effect of this issue is that the reduced initial share price of the firm net reduction is in fact in line with the decisions of the negative NPV of the project. So we can say that at the initial stage, the price of the shares reduces in line with the negative NPV of the firm's decision. The likelihood of the firm's default and losses on its debt holders create these cost of agencies or agency cost of debt. The riskiness of the firm's debt level rises with the magnitude of the agency cost. Agency cost represents this particular agency cost represents an other cost of increasing the firm leverage that will affect the firm's optimal capital structure choice. Another example that would the agency cost arise if the firm owed 0.4 million rather than 1 million to its debt holders. We have an option where there is no investment decision, then the firm's assets would worth 900,000, the debt value is 400,000 and the remaining $500,000 will accrue to the equity holders and if the firm takes a risky strategy, then the assets will worth 1.3 million or 0.3 million and with the payment of 400,000 debt out of these assets, the equity will worth 0.9 million or 0.0 million dollars. So the expected payoff to the equity holders would be 0.45 million. The equity holders will reject this risky strategy and it will be reducing the expected payoff to them. So what about an under investment issue? We see that in that particular case, the new equity issue will be 0.1 million. The firm assets value is 0.9 million. The value enhancement is 0.15 million while deducting the debt value of 0.4 million from these amounts. We have a net gain of 0.15 million for the equity holders. So equity holders are paying off of 0.15 million for an investment of 0.1 million. This means that equity holders will be accepting this new investment strategy as they are here better off in this particular case. What is leverage-ratchet effects? You see that this effect captures two observations like the existing debt holders induces a firm to increase leverage despite of the fact that it will be decreasing the firm's value. And other observation is that the shareholders will not have an incentive to decrease the leverage by buying back the debt even this decision will increase the value of the firm. This ratchet effect is an important additional agency cost of leverage affecting the firm's future growth and its other financing decision. This effect in fact induces the firms to borrow initially lesser amount in order to avoid these costs. But over time this effect may lead to higher leverage as the owner prefer to use more debt in the firm. How debt maturity can be related with the certain covenants? See that there are several ways to mitigate the firm's agency cost of debt. The first way is to use of short term debt instead of long term debt. But this reliance on short term debt will obligate the firm to repay or refinance its debt quite frequently. And also the firm's risk of financial distress will increase the cost of financial distress to an unexpected level. And the second way is that the debt covenants may be there, these debt covenants may limit the firm's ability to pay a larger amount of dividends or it may restrict the firm's investment decisions. It may also limit to acquire new debt by the firm. And it may limit the management's flexibility because this covenants decision may get in the way of the positive NPV projects and in this way these covenants can have their own cost for the firm.