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

  • Robert Parrino
  • Allen M. Poteshman
  • Michael S. Weisbach

This paper examines distortions in corporate investment decisions when a new project changes firm risk. It presents a dynamic model in which a self-interested, risk-averse manager makes investment decisions at a levered firm. The model, calibrated using data from public firms, is used to estimate the magnitude of distortions in investment decisions. Despite potential wealth transfers from debtholders, managers compensated with equity prefer safe projects to risky ones. Important factors in this decision are the expected changes in the values of future tax shields and bankruptcy costs when firm risk changes. We also evaluate the extent to which this effect varies with firm leverage, managerial risk aversion, managerial non-firm wealth, project size, debt duration, and the structure of management compensation packages.

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File URL: http://www.nber.org/papers/w8763.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8763.

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Date of creation: Jan 2002
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Publication status: published as Robert Parrino & Allen M. Poteshman & Michael S. Weisbach, 2005. "Measuring Investment Distortions when Risk-Averse Managers Decide Whether to Undertake Risky Projects," Financial Management, Financial Management Association, vol. 34(1), Spring.
Handle: RePEc:nbr:nberwo:8763
Note: CF
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  13. 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.
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  16. Graham, John R., 1996. "Proxies for the corporate marginal tax rate," Journal of Financial Economics, Elsevier, vol. 42(2), pages 187-221, October.
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