What is the underinvestment problem? Why is it a “problem”?

What is the underinvestment problem? Why is it a “problem”?

Expert Solution

The underinvestment problem also known as "debt overhang problem" ,refers to the conflict of interest between a company's shareholders and debt holders.The underinvestment problem occurs when a leveraged company has to forego a viable investment opportunity due to the fact that debt holders(creditors) get more of the benefits of the project and not leaving enough for shareholders.

Underinvestment becomes a problem when the firm has to pass on projects that could add value to the firm's market value.This often occurs when the firm's managers think that the creditors of the firm stand more to gain than the shareholders.If most or all of the positive cashflows from a project with a positive NPV(Net Present Value is one of the many capital budgeting techniques used to evaluate the viability of a project)) goes to the firm's creditors and the shareholders(owners) of the company stand to gain nothing and as a result will often lack the incentive to invest in such projects.This right here is the "problem " with underinvestment.

jeff jeffy answered 2 years ago

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