Optimal investment and endogenous payout strategy with time inconsistency

Yehong Yang and Guohua Cao

International Journal of Finance & Economics, 2021, vol. 26, issue 1, 707-723

Abstract: This study extends the classical model to focus on a firm's optimal investment and endogenous payout strategies when a manager has time‐inconsistent preferences, which we describe by a quasi‐hyperbolic discount function. We attempt to reveal the impacts of time‐inconsistency on liquidation, external financing, credit lines, and risk management. The extended model predicts that the time‐inconsistent manager tends to (a) pay out cash to shareholders earlier by lowering the dividend payment, which causes the firm to hold less cash reserves and raise less equity; (b) invest less in the high cash and engage in much less costly asset sales in the low cash; and (c) choose not to hedge earlier than a time‐consistent counterpart. In addition, our model also shows that the manager's time‐inconsistent preferences decrease firm value and the marginal value of cash. These results highlight that corporate decisions, including payouts, cash holdings, investment, external financing, and even risk management strategies, are highly dependent on the manager's time‐inconsistent preferences.

Date: 2021
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