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Dynamic Agency and the q Theory of Investment






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    • Peter M. DeMarzo is from Stanford University, Michael J. Fishman is from Northwestern University, Zhiguo He is from the University of Chicago, and Neng Wang is from Columbia University. We thank Patrick Bolton; Ron Giammarino; Cam Harvey (Editor); Christopher Hennessy; Narayana Kocherlakota; Guido Lorenzoni; Gustavo Manso; Stewart Myers; Adriano Rampini; Jean-Charles Rochet; Ajay Subramanian; Toni Whited; Mike Woodford; the referee; and seminar participants at UBC, Columbia, Duke, HKUST, Minnesota, MIT, Northwestern, Texas, Vienna, Washington University, Gerzensee, NBER, the Risk Foundation Workshop on Dynamic Risk Sharing (University of Paris, Dauphine), the Society for Economic Dynamics (Boston), Stanford SITE conference, Toulouse, the European Winter Finance Conference, the Western Finance Association, and the American Economic Association for helpful comments. This research is based on work supported in part by NBER and the National Science Foundation under grant No. 0452686, as well as the Chazen Institute of International Business at Columbia Business School.


We develop an analytically tractable model integrating dynamic investment theory with dynamic optimal incentive contracting, thereby endogenizing financing constraints. Incentive contracting generates a history-dependent wedge between marginal and average q, and both vary over time as good (bad) performance relaxes (tightens) financing constraints. Financial slack, not cash flow, is the appropriate proxy for financing constraints. Investment decreases with idiosyncratic risk, and is positively correlated with past profits, past investment, and managerial compensation even with time-invariant investment opportunities. Optimal contracting involves deferred compensation, possible termination, and compensation that depends on exogenous observable persistent profitability shocks, effectively paying managers for luck.