Dynamic agency and the q theory of investment
Coauthor(s): Peter DeMarzo, Mike Fishman, Zhiguo He.
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We develop an analytically-tractable model integrating the dynamic theory of investment with dynamic optimal incentive contracting, thereby endogenizing nancing constraints. Incentive contracting generates a history-dependent wedge between marginal and average q, and both vary over time as good (bad) performance relaxes (tightens finnancing constraints. Financial slack, not cash flow, is the appropriate proxy for nancing constraints. Investment decreases with firrm-specific risk, and is positively correlated with past profits, past investment, and managerial compensation even with time-invariant investment opportunities. Optimal contracting involves deferred compensation; possible termination; and compensation that depends on exogenous observable persistent protability shocks, effectively paying managers for luck.
Source: Journal of Finance
DeMarzo, Peter, Mike Fishman, Zhiguo He, and Neng Wang. "Dynamic agency and the q theory of investment." Journal of Finance (forthcoming).