On Debt Overhang, Non-Contractibility, and Endogenous Outside Option

In this paper I analyze a simple example of a debt contract based on an extension of the debt overhang problem. I assume incomplete contracts and introduce the possibility of refinancing an existing debt by an outside investor. Although the refinancing is never implemented in the equilibrium, it creates an outside option for the borrower that directly affects the outcome of the renegotiation. I show that depending on the values of the parameters, it either restores the efficiency by itself or with additional requirements from the borrower, such as very strict debt covenants.