The Underinvestment Problem, Bond Covenants, and Insurance

Abstract

Introduction underinvestment problem has been well known in finance since the appearance of Myers's (1977) seminal work on The Determinants of Borrowing. Myers considers a situation in which the firm has an outstanding bond issue now and may invest in a positive net present value project then.(1) payoff on the investment project is risky now but not when the decision is made then. underinvestment occurs because there are realized project payoffs that cover the investment expenditure then but not the investment expenditure and the promised payment on the bond issue. If the firm did invest in the project under these circumstances, then all net proceeds would go to bondholders. Hence, management that acts in the best interests of its shareholders never makes such an investment decision. Given rational expectations, the stock market value of the firm is larger now because of management's decision then not to invest under the conditions just described. Mayers and Smith (1987) article, Corporate Insurance and the Underinvestment Problem, builds on Myers's work. Mayers and Smith have provided an interesting and intuitively appealing discussion of the role played by insurance in bonding the corporate investment decision. Schnabel and Roumi (1989) have extended the model proposed by Mayers and Smith to a consideration of the effect of a safety, or premium loading. Although Mayers and Smith assert that the gains associated with resolving the underinvestment problem are enjoyed by shareholders, their analysis does not explicitly provide the mechanism to show how this is accomplished.(2) This article provides two routes out of this difficulty. Because the Mayers and Smith and Schnabel and Roumi models do not allow the promised debt payment to change after insurance is introduced, it follows that the debt issue raises more money with the insurance covenant than without it. Hence, current shareholders get the additional value if the manager sets a payment now equal to the difference between the debt values with and without the insurance covenant net of the insurance premium. We will refer to this later as the cum dividend interpretation of the Mayers and Smith and Schnabel and Roumi models. However, rather than confound financing and decisions unnecessarily, we propose an alternative solution that requires the imposition of a financing condition. This allows us to show that an insurance deductible may be chosen that enables the manager to also reduce the promised debt payment and restore full value for the current shareholders. Our analysis explicitly shows that an insurance covenant can be designed that allows current shareholders to capture the gain in value and that the gain in value equals the agency cost of the underinvestment problem. We believe that the introduction of a financing condition rather than a policy is more instructive, since it allows us to focus more neatly on the structure of the bond/insurance financing package. This difference becomes particularly important when premium loading is introduced, because the ability to adjust the promised debt payment allows the manager to reduce the cost due to premium loading. Underinvestment Problem Although limited liability confers a number of important economic benefits, it also has its costs (see Easterbrook and Fischel, 1985). By creating an asymmetry between the costs and benefits of risky activities, limited liability causes bondholders and shareholders to have incompatible incentives whenever the corporation's debt is subject to the risk of bankruptcy. Mayers and Smith identify a situation in which the conflict of interests is so severe that an underinvestment problem occurs. In their model, underinvestment occurs in the sense that shareholders choose to forego a positive net present value investment that, in the absence of bankruptcy risk, would be undertaken. In order to focus their analysis on the role of insurance in resolving this problem, Mayers and Smith assume that the only source of uncertainty for the firm is whether it will suffer a property loss. …