what is 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 the underinvestment problem explainedpotential conflicts of interest between managers stockholders and debtholders influence capital structure corporate governance activities and investment policies these types of agency problems in turn can give rise to inefficient managerial decisions and suboptimal investments that generally fall under the categories of problems of underinvestment and overinvestment 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 myers adds that 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 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 contradicting the modigliani miller theoremthe underinvestment problem theory is at conflict with the theoretical 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 the underinvestment problem and debt overhangone instance of the underinvestment problem is known as a debt overhang when a firm has a very large level of debt there comes a point when it can no longer borrow from creditors any longer the debt burden is so large in fact that any and all earnings that come into the company immediately go directly to paying off existing debt instead of going into new investments or projects limiting the growth of the company it leads to underinvestment in the firm as a result shareholders lose out both to creditors in the present and to future lost growth potential as well debt overhangs also apply to national governments where the sovereign debt of a nation exceeds its future capacity to repay it a debt overhang can lead to stagnant growth and the degradation of living standards from underinvestment in critical areas such as healthcare education and infrastructure 