What Is the Underinvestment Problem?

The underinvestment problem is an agency problem proposed by financial economists that exists between shareholders and debt holders, in which a 澳洲幸运5官方开奖结果体彩网:leveraged company foregoes valuable inves🎐tment opportunities because debt holders would capture a portion of the benefits of the project, leaving insufficient re🐓turns to the equity shareholders.

The Underinvestment Problem Explained

Potential conflicts of interest between managers, stockholders, and debtholders influence capital structure, corporate governance activities, and investment policies. These types of agency problems, in turn, can give rise to inefficient managerial decisions and “suboptimal” investments that generally fall under the categories of problems of underinvestment and overinvest😼ment.

The underinvestment problem in corporate finance theory is credited to Stewart C. Myers of the Sloan School at MIT, who in his "Determinants of Corporate Borrowing" article (1977) in the Journal of Financial Economics hypothesized that "a firm with risky debt outstanding, and which acts in its stockholders' interest, will follow a different decision rule than one which can issue risk-free debt or which issues no debt at all."

Myers adds that "the firm financed with risky debt will, in some states of nature, pass up valuable investment opportunities—opportunities which could make a positive net contribution to the market value of the firm."

The underinvestment problem moves into focus when a firm frequently passes up 澳洲幸运5官方开奖结果体彩网:net present value (NPV) projects because the managers, acting on behalf of shareholders, believe that creditors would benefit more than owners. If cash flows from a prospective investment go to creditors, then there would be no incentive to equity hold𓄧ers to proceed with the investment. Such an investment would increase the overall value of the firm, but it does not happen—hence, there is a "problem."

Contradicting the Modigliani-Miller Theorem

The underinvestment problem theory is at conflict with the theoretical assumption in the 澳洲幸运5官方开奖结果体彩网:Modigliani-Miller theorem that investment decisions can be made independent of financing decisions. Managers of a leveraged company, Myers argues, do in fact take intoꦿ consideration the amount of debt that needs to be serviced when evaluating a new investment project.

According to Myers, the value of the firm can be influenced by financing decisions, in contradiction to Modigliani-Miller's central tenet.

The Underinvestment Problem and Debt Overhang

One instance of the underinvestment problem is known as a 澳洲幸运5官方开奖结果体彩网:debt overhang. When a firm has a very large level of debt, there comes a point when it can no longer borrow from creditors any longer. The debt burden is so large, in fact, that any and all earnings that come into the company immediately go directly to paying off existing debt instead of going into new investments or projects, limiting the growth of the company. It leads to underinvestmꦡent in the firm. As a result, shareholders lose out both to creditors in the present and to future lost growth potential as well.

Debt overhangs also apply to national governments, where the sovereign debt of a nation exceeds its future capacity to repay it. A debt overhang can lead to stagnant growth and the degradation of 澳洲幸运5官方开奖结果体彩网:living standards from underinve🌄stment in 🍃critical areas such as healthcare, education, and infrastructure.