A Model of Market Discipline

Abstract

We develop an equilibrium model where refinancing and managerial incentives are jointly determined to quantify external finance's influence on management's ex ante behavior. In its calibration to US data we find that free cash flow is directed primarily towards mitigating agency conflicts, not financial frictions. Its counterfactuals suggest that firm value can be raised by 40 basis points either by decreasing agency conflicts by 1 percent or by increasing fixed refinancing costs by 4 percent, as this makes shareholders' threat of terminating management much more credible, substantially improving incentives despite the enlarged refinancing cost.

Keywords: Financial Frictions, Agency Conflicts, Dynamic Contracting, Market Discipline

JEL Classification: D21, D61, D92, G32, G35, L22