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A Theory of Firm Decline

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  • Gian Luca Clementi
  • Thomas F. Cooley
  • Sonia Di Giannatale

Abstract

We study the problem of an investor who buys an equity stake in an entrepreneurial venture, under the assumption that the former cannot monitor the latter’s operations. The dynamics implied by the optimal incentive scheme is rich and quite different from that induced by other models of repeated moral hazard. In particular, our framework generates a rationale for firm decline. As young firms accumulate capital, the claims of both investor (outside equity) and entrepreneur (inside equity) increase. At some juncture, however, even as the latter keeps on growing, invested capital and firm value start declining and so does the value of outside equity. The reason is that incentive provision is costlier the wealthier the entrepreneur (the greater is inside equity). In turn, this leads to a decline in the constrained–efficient level of effort and therefore to a drop in the return to investment.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15192.

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Date of creation: Jul 2009
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Handle: RePEc:nbr:nberwo:15192

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  1. Khan, Aubhik & Ravikumar, B., 2001. "Growth and risk-sharing with private information," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 499-521, June.
  2. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  3. Sandro Brusco & Eva Ropero, 2007. "Financing Constraints and Firm Dynamics with Durable Capital," Department of Economics Working Papers 07-08, Stony Brook University, Department of Economics.
  4. Espino, Emilio, 2004. "On Ramsey's Conjecture: Efficient Allocations in the Neoclassical Growth Model with Private Information," Economics Series 154, Institute for Advanced Studies.
  5. Bohacek Radim, 2005. "Capital Accumulation in Private Information Economies," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-24, December.
  6. Peter M. Demarzo & Michael J. Fishman & Zhiguo He & Neng Wang, 2012. "Dynamic Agency and the q Theory of Investment," Journal of Finance, American Finance Association, vol. 67(6), pages 2295-2340, December.
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Cited by:
  1. Tsyrennikov, Viktor, 2013. "Capital flows under moral hazard," Journal of Monetary Economics, Elsevier, vol. 60(1), pages 92-108.
  2. Mele, Antonio, 2011. "Repeated moral hazard and recursive Lagrangeans," MPRA Paper 30310, University Library of Munich, Germany.
  3. Emilio Espino, 2012. "Investment and Insurance in an Economic Union," 2012 Meeting Papers 1176, Society for Economic Dynamics.
  4. Loderer, Claudio & Waelchli, Urs, 2010. "Firm age and performance," MPRA Paper 26450, University Library of Munich, Germany.
  5. Hengjie Ai & Rui Li, 2012. "Moral hazard, investment, and firm dynamics," CQER Working Paper 2012-01, Federal Reserve Bank of Atlanta.

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