Underinvestment Problem

Updated on 2023-08-29T11:58:32.471151Z

What is the underinvestment problem?

The underinvestment problem was proposed by the financial economists and was defined as an agency problem that exists among the debt holders and shareholders. The underinvestment problem arises when the leveraged company skips the investment opportunities because the benefits and the returns will be limited to the debt holders and the returns of the shareholders will decline.

Frequently Asked Questions (FAQs)

What is the history of the Underinvestment problem?

The investment policies, corporate governance related activities and the capital structure of a company are affected significantly when a situation of conflict arises amongst the debtholders, shareholders and managers. These are categorised as agency problems that result in inefficient decision making and suboptimal investments. These problems are either overinvestment or underinvestment problems.

Stewart C. Myers introduced the under-investment problem through his research paper “Determinants of Corporate Borrowing” which was published in the Journal of Financial Economics in 1977. The study aimed at testing the hypothesis that a firm that prioritises the interest of shareholders over debenture holders along with risky debt outstanding will make a decision other than issuing no debt and issuing risk-free debt.

The issue of underinvestment comes in the limelight when the management is constantly passing the projects that promise higher Net Present Value (NPV) because the management is taking into consideration the perspective of shareholders and does not want to pass the benefit to the credits in comparison to the owners. In case the cash flows into the account of the creditors, then the incentive to maintain the equity investment will reduce. By investing in the projects that do not increase the value of the firms, then the problem arises.

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Why the underinvestment problem occurs?

The underinvestment problem arises because companies defy to invest in low risk projects as the low risk projects will not increase the wealth of the shareholders or value of the company.

The underinvestment problem is similar to the asset substitution problem. In asset substitution, the high risk projects are exchanged for the low risk projects by the shareholders, to generate a higher return.

In both asset substitution and underinvestment problems, the wealth of shareholders is increased on the cost of the debtholders. If the investment is made in the low risk project then the income of debtholders will increase and the profit might not reach the shareholders.

The projects with high risk have the capability to generate higher returns, as the investor is undertaking higher risks. In this case, the shareholder is also benefited as a fixed portion of cash is distributed among the debt holders. By investing in high risk projects, the debt holders are not benefited as they are not given anything in exchange for the high risk projects.

What is the concept of debt overhang in the underinvestment problem?

Debt overhang is a part of the underinvestment problem. When a firm reaches a specific level of debt then the firm can no longer make any more borrowings from the market. in some cases, the debt burden becomes so heavy that all the earnings of the firm go into paying the return or interest on the existing debt as a result, the company is not able to invest the earnings in new projects, thus, limiting the growth prospects of the company. In effect, the firm faces the problem of underinvestment in which the firm is not able to raise more funds through issuing debts and also the company is losing the opportunity to invest in other projects that might help in the growth of the firm. The concept of the debt overhang is also applicable in the case of the national governments, that is, the national government cannot make further borrowings if it reaches a point where it cannot repay in the future. The situation or problem of debt overhang results in limiting the country’s growth along with significant effects in the area of infrastructure, education and healthcare.

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How underinvestment problem contradicts the Modigliani Miller theorem?

The assumptions of the Modigliani Miller theorem and the underinvestment problem are in conflict with each other. The Modigliani Miller Theorem states that the investment decisions and investment decisions are independent, that is, the investment decision is not affected by the investment decision. It has been argued by the academicians that the underinvestment problem takes into consideration the debt amount while making investments in the new projects in order to ensure the overall growth of the shareholders.

The underinvestment problem argues that the firm’s value is affected by financing decisions, and it stands in contradiction to Modigliani Miller theorem.

What is the difference between the overinvestment and underinvestment problem?

The issue related to overinvestment arises when the management exploits their decision making power by entering projects that are profitable neither for the equity holders nor for the debt holders. Moreover, these types of projects are highly risky or have negative net present value.

The overinvestment problem occurs when there is a conflict amongst the shareholders and managers when the management over-invest in a risky project. The problem can also be caused because of the conflict between the debtholders and shareholders when the resource management policies are seen as optimal by the management but is not in favour of debtholders.

In some cases, the issue of overinvestment occurs because of the managerial confidence, that is, the manager makes the investment decision with the aim to increase the shareholder’s value but ends up overestimating the value of the project, but in reality, the value is not even positive.