Asset Substitution and Underinvestment: A Dynamic View

Abstract

Asset substitution and underinvestment are two of the most discussed agency problems in finance. A recent empirical study by Graham and Harvey (2001), however, finds little evidence that corporate executives are concerned about asset substitution and underinvestment problems when they make firms' investment and financing decisions. This paper notices that the two problems are formulated based on one-shot relationships between equity holders and debt holders. The paper examines these two issues in multi-period dynamic arrangements. It is found that if a firm issues debt only once, then the firm has an incentive to increase the firm risk after the debt is in place. If a firm wants to issue debt periodically, however, in order to capture the tax benefit associated with all future debts, the firm may not have an incentive to increase its risk. It is also found that the underinvestment problem can be greatly reduced or even essentially eliminated in a dynamic model because undertaking an investment now benefits equity holders in the future.

Keywords: Asset Substitution, Underinvestment, Growth Options, Dynamic Models

JEL Classification: G31, G32