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Measuring Investment Distortions when Risk-Averse Managers Decide Whether to Undertake Risky Projects

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Author Info
Robert Parrino
Allen M. Poteshman
Michael S. Weisbach

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Abstract

We create a dynamic model in which a self-interested, risk-averse manager makes corporate investment decisions at a levered firm with characteristics typical of public US firms. We examine the magnitude of distortions in those decisions when a new project changes firm risk and find expected changes in the values of future tax shields and bankruptcy costs to be important factors. We evaluate the extent to which these distortions vary with firm leverage, debt duration, project size, managerial risk aversion, managerial non-firm wealth, and the structure of management compensation packages.

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Publisher Info
Article provided by Financial Management Association in its journal Financial Management.

Volume (Year): 34 (2005)
Issue (Month): 1 (Spring)
Pages:
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Handle: RePEc:fma:fmanag:parrinopoteshmanweisbach05

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Lisa Meulbroek, 2001. "The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options," Financial Management, Financial Management Association, vol. 30(2), Summer.
  2. John R. Graham & Clifford W. Smith, 1999. "Tax Incentives to Hedge," Journal of Finance, American Finance Association, vol. 54(6), pages 2241-2262, December. [Downloadable!] (restricted)
  3. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October. [Downloadable!] (restricted)
  4. Graham, John R., 1996. "Proxies for the corporate marginal tax rate," Journal of Financial Economics, Elsevier, vol. 42(2), pages 187-221, October. [Downloadable!] (restricted)
  5. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July. [Downloadable!] (restricted)
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  6. Jennifer N. Carpenter, 2000. "Does Option Compensation Increase Managerial Risk Appetite?," Journal of Finance, American Finance Association, vol. 55(5), pages 2311-2331, October. [Downloadable!] (restricted)
  7. Brian J. Hall & Kevin J. Murphy, 2000. "Stock Options for Undiversified Executives," NBER Working Papers 8052, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Stein, Jeremy C., 2003. "Agency, information and corporate investment," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 2, pages 111-165 Elsevier. [Downloadable!] (restricted)
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  9. Barclay, Michael J & Smith, Clifford W, Jr, 1995. " The Maturity Structure of Corporate Debt," Journal of Finance, American Finance Association, vol. 50(2), pages 609-31, June. [Downloadable!] (restricted)
  10. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May. [Downloadable!] (restricted)
  11. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March. [Downloadable!] (restricted)
  12. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, vol. 53(4), pages 1213-1243, 08. [Downloadable!] (restricted)
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  13. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November. [Downloadable!] (restricted)
  14. Parrino, Robert & Weisbach, Michael S., 1999. "Measuring investment distortions arising from stockholder-bondholder conflicts," Journal of Financial Economics, Elsevier, vol. 53(1), pages 3-42, July. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Hong Liu & Jianjun Miao, 2006. "Managerial Preferences, Corporate Governance, and Financial Structure," Boston University - Department of Economics - Macroeconomics Working Papers Series WP2006-020, Boston University - Department of Economics. [Downloadable!]
  2. Müller, Elisabeth, 2004. "Underdiversification in Private Companies : Required Returns and Incentive Effects," ZEW Discussion Papers 04-29, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research. [Downloadable!]
  3. Zsuzsanna Fluck & Kedran Garrison & Stewart C. Myers, 2005. "Venture Capital Contracting and Syndication: An Experiment in Computational Corporate Finance," NBER Working Papers 11624, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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