A Quantitative Dynamic Agency Model of Financing Constraints

46 Pages Posted: 25 Jul 2009

See all articles by Lukas Schmid

Lukas Schmid

University of Southern California - Marshall School of Business

Date Written: November 2008

Abstract

Recent theoretical research in corporate finance has highlighted the role of incentive problems between firms' investors and insiders in determining corporations' financial structures, dynamics and investment policies. Financial contracts are designed to mitigate these agency conflicts. However, most of the analysis is qualitative in nature. This paper develops a dynamic firm model in order to study the quantitative and empirical implications of optimal long-term contracts for firms' policies and returns. Using a parsimonious representation of agency conflicts between firms' outsiders and insiders, the paper embeds a dynamic contracting problem into a neoclassical model of firm dynamics. It characterizes the optimal contract using recursive techniques and then quantitatively evaluates its implications for firm financing, investment and returns. Remarkably, the empirical predictions for optimal firm behavior and return patterns under optimal long-term contracts can differ considerably from models in which financing constraints arise from commonly used reduced form pecifications of costs of external finance. This suggests a resolution for several controversies in the literature on quantitative implications of firms' financing constraints.

Keywords: Dynamic Agency, Limited Enforcement, Financing Constraints, Capital Structure, Investment, Cross-Section of Stock Returns

Suggested Citation

Schmid, Lukas, A Quantitative Dynamic Agency Model of Financing Constraints (November 2008). Available at SSRN: https://ssrn.com/abstract=1437845 or http://dx.doi.org/10.2139/ssrn.1437845

Lukas Schmid (Contact Author)

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd, HOH 431
Los Angeles, CA California 90089-1424
United States

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