Underinvestment problem

Underinvestment problem

The mirror image of the asset substitution problem, in that stockholders refuse to invest in low-risk assets to avoid shifting wealth from themselves to debtholders.

Underinvestment Problem

A situation in which a company refuses to make low-risk investments to the detriment of bondholders. The company does this in order to placate its shareholders, who seek a higher return, but this exposes bondholders to more risk without the promise of a higher return. That is, the high-risk investments or projects may not perform as expected, resulting in bankruptcy, but the nature of bonds does not allow them to participate in any extra rewards from these investments or projects. The underinvestment problem may encourage bondholders to sell their bonds. See also: Asset substitution problem.
References in periodicals archive ?
Johnson (2003) points out that the relationship between debt term and debt will depend on the trade-off between the preference to mitigate liquidity risks or the underinvestment problem.
The underinvestment problem was taken as serious for high risk projects; therefore the model predicted that receivable sales would be more likely for low risk, high credit-quality receivable.
Stulz (1990) and Myers and Majluf (1984) present models to demonstrate the underinvestment problem resulting from insufficient cash reserves.
First, the study extends prior literature and investigates whether the content of corporate disclosure plays a role in mitigating the underinvestment problem.
This means that part of the benefit of investing goes to the creditors, which is what creates the debt-overhang underinvestment problem.
Finally, the underinvestment hypothesis, developed by Bodie and Taggart (1978) and Barnea, Haugena, and Senbet (1980), demonstrates that the Myers' (1977) underinvestment problem can be resolved with a call provision.
Ross' argument implies that firms with high growth opportunities are more likely to hedge to mitigate the underinvestment problem and are less likely to increase debt capacity.
Any future replacement for the ITS would likely experience the same underinvestment problem.
But, more importantly, implementing a policy that rewards the diffusion of technology can create new incentives for additional spending on research and development, thereby potentially solving the underinvestment problem resulting from market failure.
This is the underinvestment problem identified by Myers (1977, p.
High-growth opportunity firms are more likely to face an underinvestment problem compared with low-growth opportunity firms and, thus, the negative effect of longer debt maturity on investment should be stronger for high-growth opportunity firms.
In both cases an underinvestment problem results if the marginal agency cost is positive.