Underinvestment Problem
What Is the Underinvestment Problem?
The underinvestment problem is a agency problem proposed by financial business analysts that exists among shareholders and debt holders, in which a leveraged company foregoes important investment opportunities since debt holders would capture a portion of the benefits of the project, passing on lacking returns to the equity shareholders.
The Underinvestment Problem Explained
Expected conflicts of interest between managers, investors, and debtholders influence capital structure, corporate governance activities, and investment policies. These types of agency problems, thus, can bring about inefficient managerial decisions and "poor" investments that generally fall under the categories of problems of underinvestment and overinvestment.
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 estimated that "a firm with risky debt outstanding, and which acts to its greatest advantage's, will follow an alternate decision rule than one which can issue risk-free debt or which issues no debt by any stretch of the imagination."
That's what myers adds "the firm financed with risky debt will, in certain states of nature, miss significant investment opportunities — opportunities which could make a positive net contribution to the market value of the firm."
The underinvestment problem moves into center when a firm regularly misses net present value (NPV) projects on the grounds that the managers, following up for shareholders, accept that creditors would benefit more than owners. In the event that cash flows from a prospective investment go to creditors, there would be no incentive to equity holders to continue with the investment. Such an investment would increase the overall value of the firm, yet it doesn't work out — consequently, there is a "problem."
Going against the Modigliani-Miller Theorem
The underinvestment problem theory is at conflict with the hypothetical assumption in the Modigliani-Miller theorem that investment decisions can be pursued independent of financing choices. Managers of a leveraged company, Myers contends, do as a matter of fact think about the amount of debt that should be overhauled while assessing another investment project.
As per Myers, the value of the firm can be influenced by financing decisions, in logical inconsistency to Modigliani-Miller's central tenet.
The Underinvestment Problem and Debt Overhang
One example of the underinvestment problem is known as a debt overhang. At the point when a firm has an exceptionally large level of debt, there comes a point when it can never again borrow from creditors any longer. The debt burden is so large, as a matter of fact, that all earnings that come into the company promptly go straightforwardly to paying off existing debt as opposed to going into new investments or projects, limiting the growth of the company. It leads to underinvestment in the firm. Thus, shareholders miss out both to creditors in the present and to future lost growth potential also.
Debt overhangs likewise apply to national states, where the sovereign debt of a nation surpasses its future capacity to repay it. A debt overhang can lead to stale growth and the debasement of [living standards](/way of life) from underinvestment in critical regions like healthcare, education, and infrastructure.
Features
- The underinvestment problem portrays a problem by which a company turns out to be overleveraged to the point that it can never again create investments in growth open doors.
- Financial experts perceive this situation as an agency problem that can arise between a firm's debt holders and equity shareholders.
- Debt overhang, both in terms of corporations and legislatures, is a form of the underinvestment problem that negatively impacts either shareholders or a nation's residents.
