THE UNDERINVESTMENT PROBLEM, BOND COVENANTS AND INSURANCE

James R. Garven and Richard D. Macminn

Risk and Insurance from University Library of Munich, Germany

Abstract: This article complements the earlier work by Mayers and Smith (1987) and Schnabel and Roumi (1989) which showed that a property insurance contract could be used to bond subsequent corporate investment decisions. Although these models suggest one possible approach to solving the underinvestment problem, neither model explicitly specifies the economic mechanism(s) required to guarantee that current shareholders receive the maximum possible benefits from solving this problem. We propose a financing-constrained model that not only eliminates underinvestment but also ensures that current shareholders capture the entire agency cost (net of loading) as an increase in value.

Keywords: corporate risk management; underinvestment; agency cost; bonding (search for similar items in EconPapers)
Date: 1994-07-14
Note: Postscript (ASCII) UNDERINVS.ABS
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