The underinvestment problem is an agency issue proposed by financial economists. It occurs when a leveraged company skips valuable investment opportunities because debt holders would capture a portion of the benefits, leaving insufficient returns to equity shareholders. This problem poses significant challenges for growing companies and is critical to understanding corporate finance dynamics.
Key Insights
- The underinvestment problem depicts a scenario where overly leveraged companies cannot invest in growth opportunities.
- Economists identify it as an agency issue between a company’s debt holders and shareholders.
- The concept of debt overhang, applicable to both corporations and governments, negatively impacts shareholders or citizens.
The Underinvestment Problem Explained
Conflicts of interest between managers, stockholders, and debtholders influence capital structure, corporate governance, and investment policies. These agency issues can result in inefficient decisions and “suboptimal” investments, generally falling into the categories of underinvestment and overinvestment.
The concept of the underinvestment problem in corporate finance is credited to Stewart C. Myers of the Sloan School at MIT. In his 1977 article, Determinants of Corporate Borrowing, Myers hypothesized that a firm with risky debt would act in the interests of its stockholders, which leads it to follow different decision rules than one issuing risk-free debt or no debt at all. Myers argued that firms financed with risky debt might sometimes pass up valuable investment opportunities, providing a net positive contribution to the firm’s market value.
The underinvestment issue arises when a firm consistently forgoes net present value (NPV) projects due to managerial beliefs that creditors would benefit more than shareholders. This lack of incentive toward equity holders means investments that would otherwise increase the firm’s value do not occur, leading to the so-called “problem.”
Challenging the Modigliani-Miller Theorem
The underinvestment problem conflicts with the Modigliani-Miller theorem, which posits that investment decisions can be made irrespective of financing decisions. Myers contended that managers of leveraged companies consider the debt to be serviced when assessing new investment projects, implying that financing decisions can affect a firm’s value, opposite of the Modigliani-Miller central tenet.
The Underinvestment Problem and Debt Overhang
A particular instance of the underinvestment problem is known as debt overhang. This occurs when a firm has so much debt that it cannot borrow further. Any profits the firm makes go directly to paying off the debt instead of fueling new investments or projects, thereby undercutting corporate growth. Consequently, shareholders suffer, losing out in both immediate returns to creditors and future growth potential.
Debt overhang similarly affects national governments, where sovereign debt exceeds repayment capacity. This condition stifles growth and deteriorates living standards due to underinvestment in vital sectors like healthcare, education, and infrastructure.
Related Terms: agency problem, net present value, Modigliani-Miller theorem.
