A Quantitative Dynamic Agency Model of Financing Constraints
46 Pages Posted: 25 Jul 2009
Date Written: November 2008
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
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