The Underinvestment and Overinvestment Hypotheses: An Analysis Using Panel Data

Abstract

In this paper we study the relationship between firm value and investment in order to test the underinvestment and overinvestment hypotheses. The results obtained, using panel data methodology as the estimation method, indicate that the abovementioned relation is quadratic, which implies that there exists an optimal level of investment. As a consequence, firms that invest less than the optimal level suffer from an underinvestment problem, while those firms that have a level of investment higher than the optimum suffer from an overinvestment problem. The aforementioned quadratic relation is maintained when firms are classified depending on their investment opportunities. Moreover, in accordance with the theory, those firms with valuable investment opportunities maintain an optimal level of investment higher than that of those whose investment opportunities are of low quality.

Keywords: underinvestment, overinvestment, investment opportunities