Working Paper: CEPR ID: DP12588
Authors: Dirk Hackbarth; Alejandro Rivera; Takyuen Wong
Abstract: This paper studies incentives in a dynamic contracting framework of a levered firm. In particular, the manager selects long-term and short-term efforts, while shareholders choose initially optimal leverage and ex-post optimal default policies. There are three results. First, shareholders trade off the benefits of short-termism (current cash flows) against the benefits of higher growth from long-term effort (future cash flows), but because shareholders only split the latter with bondholders, they find short-termism ex-post optimal. Second, bright (grim) growth prospects imply lower (higher) optimal levels of short-termism. Third, the endogenous default threshold rises with the substitutability of tasks and, for a positive correlation of shocks, the endogenous default threshold is hump-shaped in the volatility of permanent shocks, but increases monotonically with the volatility of transitory shocks. Finally, we quantify agency costs of short-term and long-term effort, cost of short-termism, effects of investor time horizons, credit spreads, and risk-shifting.
Keywords: capital structure; contracting; multitasking
JEL Codes: D86; G13; G32; G33; J33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Shareholders' decisions on optimal leverage and default policies (G32) | short-termism (G31) |
| short-termism (G31) | default risk (G33) |
| firm growth prospects (D25) | allocation of managerial efforts (M54) |
| volatility of permanent shocks (C22) | endogenous default threshold (G33) |
| transitory shocks (E32) | endogenous default threshold (G33) |
| short-termism (G31) | agency costs (G34) |
| agency costs (G34) | firm value (G32) |