Financing a Black Box: Dynamic Investment with Persistent Private Information

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