52 Pages Posted: 30 Oct 2017 Last revised: 3 Nov 2018
Date Written: October 29, 2018
This paper studies incentives in a dynamic contracting framework of a levered firm. In particular, the manager selects long-term and short-term efforts, while shareholders choose initially optimal leverage and ex-post optimal default policies. Notably, a resource constraint that binds the agent's effort captures the essence of short-termism: an increase in short-term effort makes long-term effort costlier thereby undermining long-term performance. There are three results. First, shareholders trade off the benefits of short-termism (current cash flows) against the benefits of higher growth from long-term effort (future cash flows), but because shareholders only split the latter with bondholders, excessive short-termism ex-post is optimal for shareholders. Second, bright (grim) growth prospects imply lower (higher) optimal levels of short-termism. Third, the endogenous default threshold rises with the substitutability of tasks and, for a positive correlation of shocks, the endogenous default threshold is hump-shaped in the volatility of permanent shocks, but increases monotonically with the volatility of transitory shocks. Finally, we quantify agency cost of excessive short-termism, which underscores the economic significance of our results.
Keywords: Capital Structure, Contracting, Multi-Tasking
JEL Classification: D86, G13, G32, G33, J33
Suggested Citation: Suggested Citation