Agency problems between managers and shareholders affect both investment and capital structure decisions at firms. In “Agency Conflicts and Investment: Evidence from a Structural Estimation,” Redouane Elkamhi, Daniel Kim, Chanik Jo, and Marco Salerno develop and structurally estimate a dynamic model to understand the real and financial implications of such agency problems.
The manager in the model is pulled into two different directions. On the one hand, there is the quiet life hypothesis. The manager derives private benefits out of the firm’s net income, which provides an incentive to reduce leverage. Because investment projects are often financed with debt, this effect leads to underinvestment relative to the first-best level. On the other hand, the manager’s compensation can depend on the size of the firm, which provides an empire-building incentive to overinvest.
Which of these two effects is more important in the real world? The authors structurally estimate the model on a sample of large US public firms over the period 1993 to 2019. The structural parameters are chosen to match the leverage, Tobin’s q, and managerial compensation from the data. The average firm in the sample overinvests by about 8% compared to a world with no agency conflicts. There is heterogeneity across firms based on the characteristics of the CEO, with investment being higher for firms with younger CEOs but somewhat paradoxically also firms with longer-tenured. Overall, the results suggest that the empire-building motive dominates the incentives to underinvest.
Spotlight by Uday Rajan
Photos courtesy of Redouane Elkamhi, Daniel Kim, Chanik Jo, and Marco Salerno