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The Underinvestment Problem, Bond Covenants and Insurance

Author

Listed:
  • Garven, J. R.
  • R. D. MacMinn

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.

Suggested Citation

  • Garven, J. R. & R. D. MacMinn, "undated". "The Underinvestment Problem, Bond Covenants and Insurance," Working Papers 011, Risk and Insurance Archive.
    • Handle: RePEc:wop:riskar:011
    as

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    References listed on IDEAS

    as
    1. Bodie, Zvi & Taggart, Robert A, Jr, 1978. "Future Investment Opportunities and the Value of the Call Provision on a Bond," Journal of Finance, American Finance Association, vol. 33(4), pages 1187-1200, September.
    2. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    3. Smith, Clifford Jr. & Warner, Jerold B., 1979. "On financial contracting : An analysis of bond covenants," Journal of Financial Economics, Elsevier, vol. 7(2), pages 117-161, June.
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