Measuring Investment Distortions When Risk-Averse Managers Decide Whether to Undertake Risky Projects

56 Pages Posted: 2 Feb 2002 Last revised: 27 Feb 2002

See all articles by Robert Parrino

Robert Parrino

University of Texas at Austin - Department of Finance

Allen M. Poteshman

University of Illinois at Urbana-Champaign - Department of Finance

Michael S. Weisbach

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 3 versions of this paper

Date Written: January 2002

Abstract

This paper examines distortions in corporate investment decisions when a new project changes firm risk. It presents a dynamic model in which a self-interested, risk-averse manager makes investment decisions at a levered firm. The model, calibrated using data from public firms, is used to estimate the magnitude of distortions in investment decisions. Despite potential wealth transfers from debtholders, managers compensated with equity prefer safe projects to risky ones. Important factors in this decision are the expected changes in the values of future tax shields and bankruptcy costs when firm risk changes. We also evaluate the extent to which this effect varies with firm leverage, managerial risk aversion, managerial non-firm wealth, project size, debt duration, and the structure of management compensation packages.

Suggested Citation

Parrino, Robert and Poteshman, Allen M. and Weisbach, Michael S., Measuring Investment Distortions When Risk-Averse Managers Decide Whether to Undertake Risky Projects (January 2002). NBER Working Paper No. w8763. Available at SSRN: https://ssrn.com/abstract=299186

Robert Parrino

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-471-5788 (Phone)
512-471-5073 (Fax)

Allen M. Poteshman

University of Illinois at Urbana-Champaign - Department of Finance ( email )

340 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
United States
217-265-0565 (Phone)
217-244-3102 (Fax)

HOME PAGE: http://www.business.uiuc.edu/poteshma

Michael S. Weisbach (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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