Agency, Corporate Liquidity, and Optimal Investment Horizon

Abstract

We develop a liquidity management model with dynamic agency. The agent controls short-term investment, which affects the current profitability, and long-term investment, which determines the firm growth. Regardless of the correlation between transitory cash flow and permanent growth shocks, the optimal contract implements excessive short-term investment, leading to corporate short-termism. Our model predicts that distressed firms behave more short-termist and firms with a higher correlation between shocks implement riskier and longer-term policies. Moreover, the cash-flow sensitivity of cash is non-monotonic in agency frictions and levered firms may shift cash flow risk from the agent to creditors, mitigating overinvestment in short term.

Keywords: optimal contract, liquidity management, short-termism

JEL Classification: D86, G31, G32