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Dynamic Agency and the Q Theory of InvestmentPeter M. DeMarzoStanford Graduate School of Business; National Bureau of Economic Research (NBER) Michael J. FishmanKellogg School of Management - Department of Finance Zhiguo HeUniversity of Chicago - Booth School of Business, and NBER Neng WangColumbia Business School - Finance and Economics April 29, 2012 Journal of Finance, Forthcoming 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.
Number of Pages in PDF File: 70 Accepted Paper SeriesDate posted: April 30, 2012Suggested CitationContact Information
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