Temporal Resolution of Uncertainty, the Investment Policy of Levered Firms and Corporate Debt Yields
Stern School of Business, Department of Finance Working Paper No. Fin-99-044
48 Pages Posted: 11 Mar 2002
Date Written: March 1, 2002
This paper attempts to link the agency literature (concerned with the fact that tensions between bondholders and shareholders may trigger suboptimal investment decisions) with the one dealing with temporal resolution of uncertainty (TRU). We consider here how the speed of resolution of the uncertainty characterizing the firm's operations affects the risk-shifting behavior of a shareholder-aligned manager. It is assumed that investors are risk neutral and that the return on the risky technology is normally distributed. It is shown that the speed of TRU affects monotonically the extent of risk shifting as well as bond yields, even after optimal contracts mitigating deviations from the first-best investment policy have been written. In particular, the optimal investment-restricting covenant is endogenously characterized. Empirical implications are derived and discussed.
Keywords: Agency costs, temporal resolution of uncertainty, corporate debt yields, optimal contracts
JEL Classification: G13, G31, L14
Suggested Citation: Suggested Citation