Underinvestment Problem

AAA

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.

INVESTOPEDIA EXPLAINS '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.

RELATED TERMS
  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. Agent

    1. An individual or firm that places securities transactions ...
  4. Asset Substitution Problem

    A problem that arises when a company exchanges its low-risk assets ...
  5. Agency Costs

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

    A conflict of interest inherent in any relationship where one ...
Related Articles
  1. The Basics Of Corporate Structure
    Investing Basics

    The Basics Of Corporate Structure

  2. Governance Pays
    Options & Futures

    Governance Pays

  3. Who is responsible for protecting and ...
    Investing

    Who is responsible for protecting and ...

  4. Examples Of Using SWOT Analysis To Get ...
    Investing Basics

    Examples Of Using SWOT Analysis To Get ...

comments powered by Disqus
Hot Definitions
  1. Letter Of Credit

    A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. ...
  2. Due Diligence - DD

    1. An investigation or audit of a potential investment. Due diligence serves to confirm all material facts in regards to ...
  3. Certificate Of Deposit - CD

    A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate ...
  4. Days Sales Of Inventory - DSI

    A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory ...
  5. Accounts Payable - AP

    An accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable ...
  6. Ratio Analysis

    Quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items ...
Trading Center