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 ?
This is the underinvestment problem identified by Myers (1977, p.
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.
Any future replacement for the ITS would likely experience the same underinvestment problem.
Some of the contractual solutions to the underinvestment problem rely on complex direct-revelation mechanisms that utilize private or unverifiable information to implement efficient investments as in, for example, Rogerson (1992) and Maskin and Tirole (1999), but they are not robust to renegotiation.
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.
The agency costs of the underinvestment problem are particularly high for firms having both high leverage and growth opportunities.
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.
Hadlock (1998) provides a model in which increasing managements' share of shareholder wealth changes exacerbates the Myers/Majluf underinvestment problem.
Two common examples are the asset substitution problem and the underinvestment problem introduced by Jensen and Meckling (1976) and Myers (1977).
At the same time, Stulz and Johnson (1985) have shown that high-priority claims, such as leasing, can help mitigate the underinvestment problem relative to other forms of debt.