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Measuring investment distortions when risk-averse managers decide whether to undertake risky projects

By Robert Parrino, Allen M. Poteshman and Michael S. Weisbach


We create a dynamic model in which a self-interested, risk-averse manager makes corporate investment decisions at a levered firm with characteristics typical of public US firms. We examine the magnitude of distortions in those decisions when a new project changes firm risk and find expected changes in the values of future tax shields and bankruptcy costs to be important factors. We evaluate the extent to which these distortions vary with firm leverage, debt duration, project size, managerial risk aversion, managerial non-firm wealth, and the structure of management compensation packages. The corporate finance literature has extensively modeled the distortions in investment decisions that result from conflicts of interest between claimholders. These models generally imply that firms make suboptimal project choices, either in terms of good projects that are rejected, or bad projects that are accepted. Since it is difficult to observe management forecasts of project net present values, especially for projects that are not ultimately undertaken, it is difficult to assess the importance of these models quantitatively. One approach to evaluating the importance of investment distortions is to first calibrate a model that uses data from public firms, and then estimate the magnitude of the distortion in investment decisions by examining the characteristics of the projects that the model predicts would be accepted or rejected. Studies such as those by Mello and Parsons (1992), Lelan

Year: 2005
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