Underinvestment Hypothesis Statement

What is an 'Underinvestment Problem'

An underinvestment problem is an agency problem between shareholders and debt holders where a leveraged company foregoes valuable investment opportunities because debt holders would capture a portion of the benefits of the project, leaving insufficient returns to shareholders.

BREAKING DOWN 'Underinvestment Problem'

The underinvestment problem in corporate finance theory is credited to Stewart C. Myers of the Sloan School at M.I.T., who in his "Determinants of Corporate Borrowing" article (1977) in the Journal of Financial Economics hypothesized that "a firm with risky debt outstanding, and which acts in its stockholders' interest, will follow a different decision rule than one which can issue risk-free debt or which issues no debt at all. The firm financed with risky debt will, in some states of nature, pass up valuable investment opportunities — opportunities which could make a positive net contribution to the market value of the firm." Also known as the "debt overhang problem," the underinvestment problem moves into focus when a firm frequently passes up net positive NPV projects because the managers, acting on behalf of shareholders, believe that creditors would benefit more than owners. If cash flows from a prospective investment go to creditors, then there would be no incentive to equity holders to proceed with the investment. Such an investment would increase the overall value of the firm, but it does not happen — hence, there is a "problem."

Contradicting Modigliani-Miller

The underinvestment problem theory conflicts with the assumption in the Modigliani-Miller Theorem that investment decisions can be made independent of financing decisions. Managers of a leveraged company, Myers argues, do in fact take into consideration the amount of debt that needs to be serviced when evaluating a new investment project. According to Myers, the value of the firm can be influenced by financing decisions, in contradiction to Modigliani-Miller's central tenet.

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.

Callable bonds revisited

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.

Specific investments, flexible adaptation, and requirement contracts

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.

Picking winners and losers in the global technology race

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.

Debt maturity structure and firm investment

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.

CEO Ownership, Leasing, and Debt Financing

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