What is an 'Underinvestment Problem'

An underinvestment problem is 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.

RELATED TERMS
  1. Asset Substitution Problem

    A problem that arises when a company exchanges its low-risk assets ...
  2. Amortizing Security

    A class of debt security in which a portion of the underlying ...
  3. Registered Holder

    Shareholders who hold their shares directly with a company.
  4. Project Finance

    Defined by the International Project Finance Association (IPFA) ...
  5. Contract Holder

    An individual or organization who owns the rights to a debt or ...
  6. Debt Exchangeable for Common Stock ...

    A debt instrument that provides the holder with coupon payments ...
Related Articles
  1. Investing

    Not All Debt Holders Are Equal

    Senior debt is borrowed money a company repays first if the company goes out of business.
  2. Managing Wealth

    What's a Hurdle Rate?

    Hurdle rate has two meanings. In the business world, a business typically makes a decision on a capital project based on the net present value approach. To determine the net present value, the ...
  3. Small Business

    Understanding Subordinated Debt

    A loan or security that ranks below other loans or securities with regard to claims on assets or earnings.
  4. Investing

    What is the Shareholder Equity Ratio?

    The shareholder equity ratio shows how much money shareholders will receive if a company has to liquidate its assets.
  5. Investing

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  6. Personal Finance

    How To Invest When You're Deep In Debt

    Debt is one of the biggest obstacles that prevents people from investing - but it shouldn't be.
  7. Investing

    Evaluating A Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  8. Investing

    To Invest Or To Reduce Debt, That's The Question

    Find out how you can make use of that excess cash and improve your financial situation.
  9. Investing

    Some Good News Is Bad News For Investors

    Some companies excel at announcing news that is bad for shareholders, but spinning it as good news.
  10. Insights

    How Debt Limits A Country's Options

    While debt is fundamentally necessary to the operation of a national government, it can also be limiting and dangerous.
RELATED FAQS
  1. Are short-term investments a good strategy for cash-rich small businesses"?

    Learn more about investment choices available to small businesses and whether short-term investing is a smart choice for ... Read Answer >>
  2. What does the "agency cost of debt" mean?

    Agency cost of debt refers to an increase in cost of debt when the interests of shareholders and management diverge. For ... Read Answer >>
  3. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
  4. How much debt is too much when calculating capital budgeting?

    Learn how companies determine how much debt is acceptable when funding a new project by using the net present value to estimate ... Read Answer >>
  5. How do you calculate costs of capital when budgeting new projects?

    Discover how a company should estimate its costs of capital when budgeting for a new business project using the weighted ... Read Answer >>
  6. What measures should a company take if its total debt to total assets ratio is too ...

    Learn how the total debt to total assets ratio is analyzed by investors and lenders, and how a high ratio can be remedied ... Read Answer >>
Hot Definitions
  1. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  2. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  3. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  4. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  5. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  6. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
Trading Center