Underinvestment Problem

What is an ‘Underinvestment Problem’

When a corporation refuses to invest in low-risk assets in order to increase its wealth at the expense of debt holders, this is referred to as an agency dilemma. Low-risk initiatives give more security for the firm’s loan holders since they may create a consistent stream of income that can be used to repay the lenders. The stockholders do not benefit from the safe cash flow because it does not create an extra return. This results in the idea being rejected despite the fact that it would increase the total worth of the organization.

Explaining ‘Underinvestment Problem’

As a result of declining to participate in low-risk ventures, shareholders underinvest their resources. Similarly, the asset substitution problem occurs when owners trade low-risk assets for high-risk assets in order to maximize profits. Both scenarios will result in a rise in shareholder wealth at the expense of the loan holders’ interests. Because high-risk initiatives generate huge profits, the owners gain from greater revenue, as loan holders only demand a set part of cash flow from these investments. The problem arises as a result of the fact that debt holders are not rewarded for the increased risk.

Underinvestment Problem FAQ

What is underinvestment problem?

According to economist specialists who work among investors and shareholders, the underinvestment issue refers to a situation in which a leveraged organization foregoes important investment opportunities because its debt-holders would be entitled to a portion of the profits from the said investments, resulting in inadequate profits for the company.

What is debt overhang and why does it lead to underinvestment?

Because the debt load is so great, all profits are used to pay down existing debt rather than to support new investment initiatives, increasing the likelihood of defaulting on debt. Inflationary pressures from debt overhangs can lead to underinvestment, which retards development and makes recovery even more difficult.

What is the debt overhang problem?

Debt overhang occurs when the weight of existing debt on a company's balance sheet develops to the point that the company stands a substantial danger of defaulting on its obligations. As a result, the market value of the debt falls well short of its face value, resulting in a large loss of capital.

What is the effect of under investment on the market?

When underinvestment issues occur, new investments may be made, which may result in an increase in the market value of the company. When there is an overinvestment problem, on the other hand, more investments might result in a decrease in the market value of the company.

Further Reading