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Neoclassical Investment with Moral Hazard

Authors 
João Ejarque
Publication Year 
2004
JEL Code 
E22 - Capital; Investment (including Inventories); Capacity
G34 - Mergers; Acquisitions; Restructuring; Corporate Governance
Abstract 
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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