Underinvestment and the design of performance-sensitive debt

This paper examines the investment decision of a firm that uses performance-sensitive debt (PSD) financing. Using a real-option model of investment, we show that PSD can mitigate the well-known underinvestment problem (Myers, 1977) because of its risk-compensating nature. We also show how to design the PSD so that the underinvestment incentive is completely eliminated, thus reducing the “underinvestment” agency cost to zero. Finally, we show …