A Unified Model of Distorted Investment: Theory and Evidence

58 Pages Posted: 17 Oct 2002

Date Written: April 24, 2002

Abstract

This paper develops and tests a model of investment that integrates six theories: Tobin's Q, costly external funds, empire building, shirking, debt overhang, and managerial myopia. In contrast to earlier theoretical work that often fails to identify empirically testable hypotheses, we link the CEO's optimality condition and estimation. In particular, a closed-form expression relating the CEO's shadow price of capital to observables is derived. The use of a unified model allows us to empirically distinguish between competing theories. There is strong evidence in favor of empire building incentives, with the effect being strongest when founder status is used as a proxy for empire preferences. In particular, the investment of CEOs that are not members of the founding family is consistent with their deriving an annual benefit of $0.40 per $1000 of installed capital, while the investment of CEOs that are members of the founding family is consistent with a benefit of $3.30 per $1000 of capital. We find substantial evidence in favor of managerial myopia, and modest evidence of costly external funds and overhang. The Q and shirking theories are rejected.

Suggested Citation

Hennessy, Christopher and Levy, Amnon, A Unified Model of Distorted Investment: Theory and Evidence (April 24, 2002). AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=334742 or http://dx.doi.org/10.2139/ssrn.334742

Christopher Hennessy (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Amnon Levy

Moody's KMV ( email )

405 Howard Street
Suite 140
San Francisco, CA 94105
United States

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