Underinvestment Problem

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. Right Of First Offer

    A contractual obligation by the owner of an asset to a rights ...
  3. Income Deposit Security - IDS

    A security that combines common stock and notes of the issuer ...
  4. Price-Based Option

    A derivative financial instrument in which the underlying asset ...
  5. Common Shareholder

    An individual, business or institution that holds common shares ...
  6. Debt Overhang

    A debt burden that is so large that an entity cannot take on ...
Related Articles
  1. Investing Basics

    Not All Debt Holders Are Equal

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

    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.
  3. Retirement

    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.
  4. Credit & Loans

    Debt Ratios: Cash Flow To Debt Ratio

    By Richard Loth (Contact | Biography)This coverage ratio compares a company's operating cash flow to its total debt, which, for purposes of this ratio, is defined as the sum of short-term borrowings, ...
  5. 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.
  6. Markets

    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.
  7. Economics

    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.
  8. Credit & Loans

    How Countries Deal With Debt

    For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly.
  9. Investing

    Total Debt to Total Assets

    Total Debt to total assets, also called the debt ratio, is an accounting measurement that shows how much of a company’s assets are funded by borrowing. In business, borrowing is also called leverage.
  10. Fundamental Analysis

    Cash Flow Statement: Analyzing Cash Flow From Financing Activities

    The financing activity in the cash flow statement measures the flow of cash between a firm and its owners and creditors.
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. What is a good debt ratio, and what is a bad debt ratio?

    Learn about the factors that influence how investors and lenders evaluate the debt ratio for a company and why the answer ... Read Answer >>
  4. What are the different ways that corporations can raise capital?

    Find out about the most common types of debt and equity capital, and how things such as interest and dividend payments factor ... Read Answer >>
  5. What happens to the voting rights on shares when the shares are used in a short sale ...

    The registered owner of the security, known as the holder of record, is the investor who retains voting rights. This means ... Read Answer >>
  6. What does it signify about the state of a company if it has unusually high shareholders' ...

    Understand the meaning and calculation of shareholder equity and what a high level of shareholder equity signifies about ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center