A situation that arises when a company invests (in fixed assets) less than it needs to compensate for depreciated assets. In this case, the company’s capital expenditure (CAPEX) falls short of its annual depreciation requirements. Firms that are financially constrained and have low opportunities to growth suffer from underinvestment problems. In other words, these firms do not have sufficient cash to invest in profitable projects or, with the availability of sufficient free cash flow, are unable to uncover or undertake such projects.

Underinvestment implies that a firm foregoes good investment opportunities (known as NPV projects). This would presumably affect a firm’s market value and growth potential. However, it is possible that foregoing positive NPV projects may not necessarily negatively impact firm value as long as the firm is able to maintain its current growth level.