Time-Inconsistent Manager Incentives and Capital Formation

The empirical literature emphasizes the importance of protecting shareholder rights by encouraging managers to deliver a high present value of payouts. We show that this alignment is dynamically self-defeating: whenever access to outside equity is possible, even if costly, and commitment is limited, compensation tied to total payouts inadvertently generates endogenous managerial short-termism through time inconsistency. Paradoxically, a manager who cannot commit to restrain future equity issuance raises substantial outside funding yet invests too little today. When managers cannot commit ex ante, they rationally discount the marginal benefit of investment at a rate below the subjective discount factor, even though managers and shareholders share the same information and discount factor. The resulting wedge raises the manager’s perceived cost of capital and reduces long-run investment. Rewarding the manager for per-share rather than total payouts removes the incentive to dilute incumbent shareholders and restores efficient issuance and investment. Among implementable contracts it maximizes the value accruing to incumbent shareholders and converges to the first-best steady state, so per-share indexing dominates absolute-payout pay for the firm’s existing shareholders.