What is the underinvestment problem why is it a problem?
The underinvestment problem is an agency problem proposed by financial economists that exists between shareholders and debt holders, in which a leveraged company foregoes valuable investment opportunities because debt holders would capture a portion of the benefits of the project, leaving insufficient returns to the …
What is the overinvestment problem?
According to Galai and Masulis (1976), Jensen and Meckling (1976), Jensen (1986), and Stulz (1990), the overinvestment problem arises when managers, considering firms as a means to increase their own capital, abuse their decision-making power by choosing projects with negative present value that could increase their …
How debt can circumvent the overinvestment problem in such a firm?
As observed by Myers (1977), short term debt can solve underinvestment because “it offers the basis of a continual renegotiation, where the firm can theoretically move to all-equity financing at any time or to another source of debt capital”. Furthermore, problems of overinvestment can also be solved in this way.
What is the meaning of underinvestment?
: an insufficient amount of investment.
What is meant by debt overhang?
Debt overhang refers to a debt burden so large that an entity cannot take on additional debt to finance future projects. This includes entities that are profitable enough to be able to reduce indebtedness over time.
What is meant by underinvestment?
What do you mean by underinvestment?
Is debt overhang causing firms to underinvest?
Although in this scenario the decision not to invest causes the firm to default, in more realistic cases, debt overhang makes firms underinvest, but does not necessarily lead them to default. It’s not just existing debt overhang that could depress investment either.
What is debt overhang hypothesis?
Debt overhang refers to a debt burden so large that an entity cannot take on additional debt to finance future projects. The burden is so large that all earnings pay off existing debt rather than fund new investment projects, making the potential for defaulting higher.
What is the definition of the underinvestment problem?
The underinvestment problem is an agency problem proposed by financial economists that exists between shareholders and debt holders, in which a leveraged company foregoes valuable investment opportunities because debt holders would capture a portion of the benefits of the project, leaving insufficient returns to the equity shareholders.
How does debt overhang affect the underinvestment problem?
Debt overhang, both in terms of corporations and governments, is a form of the underinvestment problem that negatively impacts either shareholders or a nation’s citizens. Potential conflicts of interest between managers, stockholders, and debtholders influence capital structure, corporate governance activities, and investment policies.
Why does overinvestment lead to lower stock returns?
The overinvestment problem shows that lower returns are related to higher capital expenditure growth. However, not all increasing investments lead to lower stock returns. Investment can be efficient or inefficient.
Which is better efficient investment or overinvestment?
Greater capital expenditure growth helps improve returns. These firms’ increasing investments help improve equity returns. These firms have efficient investments. The overinvestment problem shows that lower returns are related to higher capital expenditure growth. However, not all increasing investments lead to lower stock returns.