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The Dynamics of Investment, Payout and Debt

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We develop a dynamic agency model of a public corporation. Managers underinvest because of risk aversion and a binding governance constraint. They smooth rents and payout. They do not exploit interest tax shields fully. The interactions of investment, debt and payout decisions can change drastically depending on managers’ preferences. Managers with power utility set investment, debt and payout proportional to the firm’s net worth, generating a constant debt ratio. With exponential utility, investment decisions are separated from decisions about debt and payout.More profitable firms become cash cows and less profitable firms accumulate debt, as in a pecking order model.

This talk is part of the Cambridge Finance Workshop Series series.

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