Which of the following are examples of debt overhang? Which examples are likely to lead to a cutback in spending? Explain.
a. Your uncle starts a restaurants, borrowing to fund his investment. The restaurant fails, and your uncle must shut down but still must pay his debt.
b. Your parents take out a loan to buy a house. Your father is transferred to a new city, and now your parents must sell the house. The value of the house has gone up during the time your family has lived there.
c. Your friend's parents take out a loan to buy her ea condo to live in while she is at college. Meanwhile, the housing market plummets. By the time your friends leaves college, the condo os worth significantly less than the value of the loan.
d. You finish college with an honors degree in a field with many good job prospects and with $25,000 in student loans that you must repay.
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Debt overhang refers to a situation where an individual or entity has excessive debt that hinders their ability to undertake new investments or spend on other goods and services. It often occurs when the value of an asset used as collateral for a loan declines, making it difficult to fully repay the debt. Let's analyze the given examples and determine which ones are examples of debt overhang and which ones are likely to lead to a cutback in spending:
a. This example is a classic case of debt overhang. Your uncle borrowed money to start a restaurant, but it failed, and he had to shut it down. However, he is still obligated to pay his debt. In this situation, your uncle may have little income or other resources to repay the debt since the restaurant is no longer generating revenue. This debt overhang can lead to a significant cutback in your uncle's spending as he tries to allocate his limited resources towards debt repayment.
b. This example does not demonstrate debt overhang. Although your parents took out a loan to buy a house, the value of the house has increased. Therefore, if they need to sell the house due to your father's transfer, they are likely to make a profit or at least break even. The increased value of the house provides a cushion for repaying the loan, and there is no indication of a cutback in spending resulting from this situation.
c. This example is another instance of debt overhang. Your friend's parents borrowed money to buy a condo for her to live in during college. However, the housing market crashes, causing the value of the condo to plummet. As a result, the value of the asset used as collateral (the condo) is significantly less than the outstanding loan amount. This situation can lead to a cutback in spending as your friend's parents may face financial difficulties trying to repay the loan while dealing with a depreciated asset.
d. This last example is not a case of debt overhang, but rather a common situation for many college graduates. Though you finish college with student loans, you have an honors degree in a field with good job prospects. This implies that you are likely to find a well-paying job and have the means to repay your student loans without major financial strain. Consequently, there may not be a significant need for a cutback in spending in this scenario.
In summary, examples a and c illustrate debt overhang, while examples b and d do not. Debt overhang tends to lead to a cutback in spending due to limited financial resources and difficulty in fully repaying the debt.