Underinvestment Problem


DEFINITION of 'Underinvestment Problem'

An agency problem where a company refuses to invest in low-risk assets, in order to maximize their wealth at the cost of the debt holders. Low-risk projects provide more security for the firm's debt holders, since a steady stream of cash can be generated to pay off the lenders. The safe cash flow does not generate an excess return for the shareholders. As a result, the project is rejected, despite increasing the overall value of the company.

BREAKING DOWN 'Underinvestment Problem'

Shareholders under invest capital by refusing to participate in low-risk projects. This is similar to the asset substitution problem, where shareholders exchange low-risk assets for high-risk ones. Both instances will increase shareholder value at the expense of the debt holders. Since high-risk projects have large profits, the shareholders benefit from increased income, as the debt holders require only a fixed portion of cash flow. The problem occurs because the debt holders are not compensated for the additional risk.

  1. Shareholder

    Any person, company or other institution that owns at least one ...
  2. Agency Theory

    A supposition that explains the relationship between principals ...
  3. Agency Costs

    A type of internal cost that arises from, or must be paid to, ...
  4. Agency Problem

    A conflict of interest inherent in any relationship where one ...
  5. Asset Substitution Problem

    A problem that arises when a company exchanges its low-risk assets ...
  6. Agent

    1. An individual or firm that places securities transactions ...
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