A Unified Model of Distorted Investment: Theory and Evidence
58 Pages Posted: 17 Oct 2002
Date Written: April 24, 2002
This paper develops and tests a model of investment that integrates six theories: Tobin's Q, costly external funds, empire building, shirking, debt overhang, and managerial myopia. In contrast to earlier theoretical work that often fails to identify empirically testable hypotheses, we link the CEO's optimality condition and estimation. In particular, a closed-form expression relating the CEO's shadow price of capital to observables is derived. The use of a unified model allows us to empirically distinguish between competing theories. There is strong evidence in favor of empire building incentives, with the effect being strongest when founder status is used as a proxy for empire preferences. In particular, the investment of CEOs that are not members of the founding family is consistent with their deriving an annual benefit of $0.40 per $1000 of installed capital, while the investment of CEOs that are members of the founding family is consistent with a benefit of $3.30 per $1000 of capital. We find substantial evidence in favor of managerial myopia, and modest evidence of costly external funds and overhang. The Q and shirking theories are rejected.
Suggested Citation: Suggested Citation