Dynamic Agency and the Q Theory of Investment

70 Pages Posted: 30 Apr 2012

See all articles by Peter M. DeMarzo

Peter M. DeMarzo

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Michael J. Fishman

Kellogg School of Management - Department of Finance

Zhiguo He

Stanford University - Knight Management Center

Neng Wang

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER); Asian Bureau of Finance and Economic Research (ABFER)

Date Written: April 29, 2012

Abstract

We develop an analytically-tractable model integrating the dynamic theory of investment 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 firm-specific 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.

Suggested Citation

DeMarzo, Peter M. and Fishman, Michael Jay and He, Zhiguo and Wang, Neng, Dynamic Agency and the Q Theory of Investment (April 29, 2012). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2048039

Peter M. DeMarzo

Stanford Graduate School of Business ( email )

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HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)

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Michael Jay Fishman

Kellogg School of Management - Department of Finance ( email )

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Zhiguo He (Contact Author)

Stanford University - Knight Management Center ( email )

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United States

Neng Wang

Columbia University - Columbia Business School, Finance ( email )

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United States

National Bureau of Economic Research (NBER) ( email )

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United States

Asian Bureau of Finance and Economic Research (ABFER) ( email )

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