Underinvestment problem

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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 ?
Myers (1977) and Myers and Majluf (1984) argued that firms shorten debt maturity in response to underinvestment problems that are generated by managerial/owner discretion.
The overall findings are consistent with the independent director responsibility hypothesis, which suggests that independent directors play a monitoring role in managers' cash spending behavior and avoiding underinvestment problems.
difference between the overinvestment and the underinvestment problems,
Using data from 1980-2003, we find that callable bonds are often issued by firms with both information asymmetry and underinvestment problems. However, risk-shifting does not appear to be a major factor.
(1) We expect [[beta].sub.2] to be positive since firms with good investment opportunities are more likely to hedge to alleviate underinvestment problems.
Given that high-growth firms are more likely to have underinvestment problems, debt may lead to financial constraint in those firms.
This article shows that both over and underinvestment problems may arise when asset reconstitution is risky.
These results support the prediction of Myers (1977) that debt maturing after the expiration of the growth option causes underinvestment problems. 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.
The preceding proposition shows that although participating policies mitigate the risk-shifting and underinvestment problems that arise because of shareholder-policyholder incentive conflict, they exacerbate the shareholder-manager agency conflict by reducing the manager's incentive to exert effort.
Firms that have valuable investment opportunities should be concentrated in the HIGH Q subsample, so evidence consistent with underinvestment problems should appear in that subsample.
As mentioned earlier, previous studies have offered theories that relate a firm's hedging decision to factors such as reducing underinvestment problems, expected taxes, the expected costs associated with financial distress, and to managerial wealth incentives.
In Myers (1977), ex post monitoring by lenders and renegotiation of debt terms can reduce debt-related underinvestment problems. Berlin and Mester (1992) argue that because banks are well-informed and typically small in number, renegotiating covenants or payments that are too restrictive ex post is easier.