Underinvestment Problem

Love is a battlefield...and so is the management of firms.

Take the underinvestment problem, for example: a battle between shareholders and debt holders. Almost every time, the shareholders win...but only in the short-run. In the long-run, everybody loses.

The underinvestment problem is when a firm shoulda/coulda/woulda made an investment that is a clear winner—yet it doesn’t happen, because the firm is already in debt, as it’s “leveraged," and if it took on more debt, then its debt payments would be too high to fill the pockets of shareholders.

If it took on this smart investment, it would be a good thing in the long-run...otherwise, it wouldn’t be a good investment. That means it’d be good for shareholders in the long-run, too. Probably.

But that would take short-term sacrifice, and shareholders are shareholders for their dividends, so...unless shareholders agree to sacrifice short-term payouts for potential long-term benefits, a firm has an underinvestment problem. Remember, the underinvestment problem only happens if a firm is already leveraged, and isn't able to take out equity in the company to do the job instead.