Investment and CEO Compensation Under Limited Commitment

Abstract

We extend the neoclassical investment model Hayashi (1982) to allow for limited commitment on compensation contracts. We consider three types of limited commitment: i) managers cannot commit to compensation contracts that provide lower continuation utility than their outside options; ii) shareholders cannot commit to negative net present value projects; iii) limited commitment on both the manager and the shareholder sides. We characterize the optimal contract under general convex adjustment cost functions and provide examples where closed form solutions can be obtained. We show that consistent with empirical evidence, small firms invest more, grow faster, have higher Tobin's Q, and are less likely to pay dividends than large firms do under the optimal contract.

Keywords: Dynamic Contracting, Limited Commitment, Investment, Q-Theory

JEL Classification: G30