Underinvestment Problem

The underinvestment problem is the problem of an agency where the investor or any other company refuses to invest in the low risk assets, in order to maximize their wealth at the cost of the debt holders. Low risk asset are more stable and they provide maximum security to the debt holder of the company regarding the pay off of their debt as low risk projects always generate a steady stream of the income or revenue. However although the project is safe and promises a steady return but it does not pays an excessive return to the share holders as a result the project is rejected. The underinvestment project is rejected despite it increase the overall value of the company.

The basic reason behind the underinvestment problem is that shareholders under invest the capital by rejecting to invest in the low risk projects. This situation is similar to an asset substitution problem. In asset substitution problem the share holder exchange low risks projects with the high risks ones. In both the instances the value of the shareholders is increased on the expense of the debt holders of the company. The high risk project earn more for the investors as they have high rate of return due to the high risk that is being taken by the investor. In this way the shareholders are benefited in this case as the debt holders only require a steady and fixed portion of the cash flow. The problem in this scenario arises because the debt holders are not compensated due to a high risk project.

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