Financing a Black Box: Dynamic Investment with Persistent Private Information
45 Pages Posted: 29 Jun 2020 Last revised: 6 Apr 2022
Date Written: April 1, 2022
Abstract
This paper studies the implication of persistent private information on firms’ optimal financing and investment policies. In a dynamic agency model, an investor supplies capital to an entrepreneur with an opaque production technology. The entrepreneur can generate private benefit from manipulating and misreporting his productivity with a persistent negative effect on future productivity growth. Compared to standard agency-based investment models, the persistency of agency frictions rationalizes over-investment especially among firms with strong histories of cash flows but low Tobin's q, and reconciles the optimal financing policy with the empirical observations of a strong investment-cash-flow sensitivity and a weak investment-q sensitivity.
Keywords: dynamic agency, persistent private information, investment, entrepreneurship, q-theory
JEL Classification: G32, D86, D25, L26
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