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Neoclassical Investment with Moral Hazard

  • João Ejarque
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    This paper takes the neo classical model of the investment decision of the firm and adds a Moral Hazard problem to it. The Moral Hazard problem, which arises due to the separation between ownership and control, induces empirical results from sample splits, which are usually interpreted as a sign of financial constraints. These results are a consequence of the departure from the benchmark linear framework of the Neoclassical model. In short, curvature can be a result of either adjustment costs, credit constraints, or of a Moral Hazard problem if the manager has a concave utility function. In addition, the Moral Hazard problem is greatly exacerbated in the presence of a compensation structure with limited liability. This induces volatility in the firm, and depending on the model parameters can generate large losses for the firm coupled with generous compensation outcomes for management.

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    File URL: http://www.bportugal.pt/en-US/BdP%20Publications%20Research/WP200417.pdf
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    Paper provided by Banco de Portugal, Economics and Research Department in its series Working Papers with number w200417.

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    Date of creation: 2004
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    Handle: RePEc:ptu:wpaper:w200417
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    8. Hamermesh, Daniel S. & Pfann, Gerard Antonie, 1996. "Adjustment Costs in Factor Demand," CEPR Discussion Papers 1371, C.E.P.R. Discussion Papers.
    9. Andrew B. Abel & Janice C. Eberly, . "A Unified Model of Investment Under Uncertainty," Rodney L. White Center for Financial Research Working Papers 14-93, Wharton School Rodney L. White Center for Financial Research.
    10. Steven A. Sharpe, 1993. "Financial market imperfections, firm leverage and the cyclicality of employment," Finance and Economics Discussion Series 93-10, Board of Governors of the Federal Reserve System (U.S.).
    11. Russell Cooper & Joao Ejarque, 2003. "Financial Frictions and Investment: Requiem in Q," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 710-728, October.
    12. Andres Almazan & Javier Suarez, 2003. "Entrenchment and Severance Pay in Optimal Governance Structures," Journal of Finance, American Finance Association, vol. 58(2), pages 519-548, 04.
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