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Answer :
The Myers (1977) underinvestment problem refers to the tendency of managers to invest less in profitable projects than they should due to agency costs, information asymmetry, risk aversion, and managerial discretion.
This problem can be mitigated through various mechanisms that align the interests of shareholders and managers.
Here's a step-by-step explanation of the underinvestment problem:
1. Agency Costs: Agency costs occur when the interests of managers, who make investment decisions on behalf of shareholders, are not aligned with those of shareholders. Managers may be motivated to act in their own self-interest rather than maximizing shareholder value.
2. Managerial Discretion: Managers have discretion in deciding how much to invest in profitable projects. They may be tempted to underinvest to increase their personal benefits, such as job security or lower risk exposure.
3. Information Asymmetry: Managers possess more information about the company's operations, risks, and potential investment opportunities compared to shareholders. This information asymmetry can make it difficult for shareholders to assess the quality of investment decisions made by managers.
4. Risk Aversion: Managers may also exhibit risk aversion and prefer to invest in less risky projects to protect their reputation or bonuses, even if riskier projects offer higher returns.
5. Underinvestment: As a result of these factors, the underinvestment problem occurs when managers invest less in profitable projects than they should. This can lead to missed growth opportunities, reduced company value, and lower returns for shareholders.
To address the underinvestment problem, mechanisms such as performance-based compensation, monitoring by independent directors, and increased transparency can be implemented. These measures help align the interests of shareholders and managers, reducing agency costs and promoting optimal investment decisions.
In summary, the Myers (1977) underinvestment problem refers to the tendency of managers to invest less in profitable projects than they should due to agency costs, information asymmetry, risk aversion, and managerial discretion. This problem can be mitigated through various mechanisms that align the interests of shareholders and managers.
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