What Is an Underinvestment Problem?
An underinvestment problem is an agency problem between shareholders and debt holders where a leveraged company foregoes valuable investment opportunities because debt holders would capture a portion of the benefits of the project, leaving insufficient returns to shareholders.
Underinvestment Problem Explained
The underinvestment problem in corporate finance theory is credited to Stewart C. Myers of the Sloan School at MIT, who in his "Determinants of Corporate Borrowing" article (1977) in the Journal of Financial Economics hypothesized that "a firm with risky debt outstanding, and which acts in its stockholders' interest, will follow a different decision rule than one which can issue risk-free debt or which issues no debt at all.
The firm financed with risky debt will, in some states of nature, pass up valuable investment opportunities — opportunities which could make a positive net contribution to the market value of the firm." Also known as the "debt overhang problem," the underinvestment problem moves into focus when a firm frequently passes up net present value (NPV) projects because the managers, acting on behalf of shareholders, believe that creditors would benefit more than owners. If cash flows from a prospective investment go to creditors, then there would be no incentive to equity holders to proceed with the investment. Such an investment would increase the overall value of the firm, but it does not happen — hence, there is a "problem."
The underinvestment problem theory conflicts with the assumption in the Modigliani-Miller theorem that investment decisions can be made independent of financing decisions. Managers of a leveraged company, Myers argues, do in fact take into consideration the amount of debt that needs to be serviced when evaluating a new investment project. According to Myers, the value of the firm can be influenced by financing decisions, in contradiction to Modigliani-Miller's central tenet.