Optimal Short-Termism

Abstract

This paper develops a dynamic contracting (multi-tasking) model of a levered firm. In particular, the manager selects long-term and short-term efforts and shareholders choose optimal debt and default policies. Excessive short-termism ex-post is optimal for shareholders, because debt has an asymmetric effect: shareholders receive all gains from short-term effort but share gains from long-term effort. We find that grim growth prospects and shareholder impatience imply higher optimal levels of short-termism. Also, an incentive cost effect and a real option effect create non-trivial patterns for the endogenous default threshold. Finally, we quantify agency costs of excessive short-termism, which underscore the economic significance of our results.

Keywords: Capital Structure, Contracting, Multi-Tasking

JEL Classification: D86, G13, G32, G33, J33