A Quantitative Dynamic Agency Model of Financing Constraints

Recent theoretical research in corporate finance has highlighted the role of incentive problems between firms’ investors and insiders in determining corporations’ financial structures, dynamics and investment policies. Financial contracts are designed to mitigate these agency conflicts. However, most of the analysis is qualitative in nature. This paper develops a dynamic firm model in order to study the quantitative and empirical implications of optimal long-term contracts for firms’ policies and returns. Using a parsimonious representation of agency conflicts between firms’ outsiders and insiders, the paper embeds a dynamic contracting problem into a neoclassical model of firm dynamics. It characterizes the optimal contract using recursive techniques and then quantitatively evaluates its implications for firm financing, investment and returns. Remarkably, the empirical predictions for optimal firm behavior and return patterns under optimal long-term contracts can differ considerably from models in which financing constraints arise from commonly used reduced form specifications of costs of external finance. This ∗The Fuqua School of Business, Duke University, 1 Towerview Drive, Durham NC 27708, USA. Email: [email protected] †I have benefited from suggestions and discussions with Andrew Abel, Hal Cole, Jean-Pierre Danthine, Bernard Dumas, Antonio Falato, João Gomes, Urban Jermann, Guillaume Plantin, Vincenzo Quadrini, Adriano Rampini, Toni Whited and seminar participants at Duke University, London Business School, University of Wisconsin-Madison, Western Finance Assocition and American Economic Association. All errors are mine.