Dynamic Agency and the q Theory of Investment

We develop an analytically tractable model integrating dynamic investment theory with dynamic optimal incentive contracting, thereby endogenizing financing constraints. Incentive contracting generates a history-dependent wedge between marginal and average q, and both vary over time as good (bad) per...

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Bibliographic Details
Published in:The Journal of finance (New York) 2012-12, Vol.67 (6), p.2295-2340
Main Authors: DEMARZO, PETER M., FISHMAN, MICHAEL J., HE, ZHIGUO, WANG, NENG
Format: Article
Language:English
Subjects:
Agency theory
Capital investments
Cash
Cash flow
Compensation
Contracts
Deferred compensation
Dynamics
Economic shock
Financial investments
Financing
Financing methods
Incentives
Investment
Investment policy
Investment strategies
Investment value
Investments
Investors
Profitability
Profitable firms
Return on investment
Studies
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Summary:We develop an analytically tractable model integrating dynamic investment theory with dynamic optimal incentive contracting, thereby endogenizing financing constraints. Incentive contracting generates a history-dependent wedge between marginal and average q, and both vary over time as good (bad) performance relaxes (tightens) financing constraints. Financial slack, not cash flow, is the appropriate proxy for financing constraints. Investment decreases with idiosyncratic risk, and is positively correlated with past profits, past investment, and managerial compensation even with time-invariant investment opportunities. Optimal contracting involves deferred compensation, possible termination, and compensation that depends on exogenous observable persistent profitability shocks, effectively paying managers for luck.
ISSN:0022-1082
1540-6261
DOI:10.1111/j.1540-6261.2012.01787.x