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Dynamic Investment with Adverse Selection and Moral Hazard

Miguel Cantillo

No 201501, Working Papers from Universidad de Costa Rica

Abstract: This paper develops a dynamic model of capital structure and investment. In a world with low and high ability managers, the former mask as the latter, but to do so have to overstate both earnings and investment. Debt is a mechanism that eventually separates investors’ abilities, at the cost of intervening unlucky high productivity managers. Immediate separation is counterproductive, as it generates costs and no expected payoff. The security design that asymptotically implements optimal investment includes the use of excess non-operating cash, of proportional cash flow compensation, and of ”golden parachutes”. Relative to a first best case, high ability managers will underinvest. Low ability managers will generally overinvest, except when their firm is close to bankruptcy, in which case they will loot the company by underinvesting and overstating their earnings.

Keywords: Bayesian Updating; reorganizations; bankruptcy; security design (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cta, nep-dge and nep-mic
Date: 2015-03, Revised 2015-03
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