The underinvestment problem is bondholders' concern that managers will not make necessary investments if the promised debt payments end up being too large. That is, owners may prefer to pay out cash to shareholders than spend their money on maintenance and repair (or other projects). This may be in their interest if the project proceeds would more than likely only go to bondholders. Underinvestment in turn reduces the payoffs bondholders will receive, and thus the firm-value that bond purchasers are willing to pay for lending to the firm today.

For example, assume a firm has only $50 in cash and no projects. Worse, it owes creditors a promised $100 in a couple of years. Fortunately for the shareholders, in our simple example, the firm can pay $50 in dividends, and leave the bondholders with nothing. Yet, suddenly, managers find an unexpected opportunity. They can pay the $50 to start a project that will yield either $60 or $160 by the time the debt is due. The firm should undertake this project, because it is a positive NPV project. But would managers acting in the interest of shareholders be willing to do so?

Table 19.4 shows that the answer is no. Managers would prefer to pay out $50 to shareholders rather than take this positive NPV project. Most of the benefit of the project would go to cover the "debt overhang," which is something that managers who act on behalf of shareholders would not care much about.

Again, this "underinvestment problem" is a cost of debt to the firm. If the firm had chosen a zero debt capital structure ex ante, such profitable future investments would not be ignored, which in turn would increase the value at which our hypothetical owner can sell the firm.

When there is debt, equity holders may not properly take care of the assets.

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Fearing future lack of care again makes it more expensive for the firm to raise capital viadebt.

IMPORTANT: Ex post reluctance to do the right thing (such as additional maintenance investment) favors equity over debt as the cheaper financing vehicle.

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