Underinvestment Problem

As per the underinvestment problem definition, it is referred to as the agency problem by financial economists existing between debt holders and shareholders. In the given concept, a leveraged company is known to forego valuable opportunities of investment as debt holders will be capturing a part of the overall benefits of the organization while leaving ample returns to the respective equity shareholders.

Explanation of Underinvestment Problem

A probable conflict of interests involving debt holders, shareholders, and managers tend to influence the overall activities related to corporate governance, investment policies, and Capital structure. In turn, the given sets of agency problems are known to enhance improper managerial decisions along with suboptimal investments usually falling under the specifications of problems of both overinvestment and underinvestment.

The concept of underinvestment problem in the field of corporate financial theory has been given credits to Stewart C. Myers from the Sloan School MIT. Myers, in his article stating “Determinants of Corporate Borrowing” in the year 1977, explained that an organization having risk-filled debt outstanding, and the one acting in the interest of the stockholders, will be following a distinct decision principle in comparison to the one that issues risk-free debt or the one not issuing any debt at all.

As per Myers, he gives additional information that the organization that has been financed with the help of risk-filled debt would, in some specific nature states, would end up passing valuable opportunities for investment. These are the opportunities that would be contributing towards positive net results to the overall Market value of the organization.

The concept of underinvestment problem is emphasized when the organization frequently tends to pass up the projects related to NPV or Net present value. This occurs because managers who tend to act on shareholder’s behalf, have the belief that creditors would be benefitting more in comparison to that of the owners. When the cash would be flowing from some potential investment to the creditors, then there will not be any provision for incentive to the respective equity holders for proceeding with the investment. The given investment would end up in increasing the overall value of the organization. However, as it does not occur, it serves to be a problem.

Underinvestment Problem & Debt Overhang

There is one example of the underinvestment problem that goes by the name as “debt overhang.” When the organization tends to feature huge volumes of debts, there arrives a point at which the firm is not able to borrow anymore from the respective creditors. As a matter of fact, the debt burden becomes significantly large such that all Earnings coming into the firm would instantly go towards paying off the ongoing debts rather than going into new investments or new projects. This tends to limit the overall growth of the organization. It leads to the situation of underinvestment in the company. Therefore, the shareholders tend to lose out to the creditors both in the present and the future growth potential.