Dynamic Q-Theory with Agency Investment Frictions and Cross-Sectional Stock Returns

Abstract

We investigate the impact of managerial investment diversion on a firm’s investment paths and the investment-return relation in a dynamic q-theory model. When efficiency of investment is not observed by shareholders, the manager may divert investment for private benefits. An agency investment friction emerges from the cost associated with high-powered managerial compensations to prevent the investment diversion. The state-dependency of agency investment frictions predicts cross-sectional variations in the relation between investment and subsequent stock returns. Our empirical results are consistent with the model predictions and suggest that managerial agency costs influence investment levels and stock returns across U.S. firms.

Keywords: Dynamic agency, Q-theory of investment, Cross-section of stock returns

JEL Classification: G12; G14; G34; D82