A Method for Teaching Overinvestment and Underinvestment Problems in Corporate Finance Courses

Abstract

One of the most important concepts in corporate finance is agency theory. When the financiers of a firm are not also the managers of the firm, the incentives of different financiers (lenders and owners) often conflict. One of the biggest problems in agency theory is that of overinvestment and underinvestment due to misalignment of shareholder and bondholder incentives. While this problem has many real applications, the underlying concepts frequently seem quite abstract to business students. This paper presents an implementation of a simple numerical spreadsheet model that can clearly illustrate the conflicting incentives of lenders and owners that lead to overinvestment and underinvestment.