Equity Prices and the Dynamics of Optimal Corporate Governance

Abstract : Measures of firm performance and corporate governance are well known to be positively correlated, and performance-sensitivity of compensation increases in firm performance. We describe how governance affects stock prices, and in turn, how stock prices affect governance, and how compensation is affected by both of these. We present a model of firm financing structure that permits a unified analysis of corporate governance, pay sensitivity of the agent's compensation, and how these relate to stock prices and other securities issued by the firm. Our main results show why corporate governance and stock prices are positively correlated, and how governance and pay sensitivity are substitutes, which rationalises these empirical observations. Our setting allows us to analyse the impact of policy interventions like the Sarbanes-Oxley Act. We also propose a measure of governance in terms of observables of the securities the firm issues.

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Financing a Black Box: Dynamic Investment with Persistent Private Information

Abstract : This paper studies the implications of persistent private information on a firm’s optimal financing and investment policies. In a dynamic agency model, an investor supplies capital to an entrepreneur with an opaque production technology. The investor observes neither the true productivity of the technology nor the actual amount of the output produced. The entrepreneur can generate private benefit from misreporting productivity and diverting output, both of which bear a persistent negative effect on the long-term growth of the technology. In contrast to the predictions of standard investment models, the persistence of the agency friction rationalizes over-investment especially among firms with a strong history of cash flow but a low Tobin’s q, and reconciles the optimal financing policy with the empirical observations of a strong investment-cash-flow sensitivity and a weak or even negative investment-q sensitivity.

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The Crisis of Expertise

Abstract : An expert advises a sequence of principals on their actions to match a hidden, randomly evolving state. The expert privately knows her competence. The principals learn about the state and the expert's competence from past advice and past action outcomes, both publicly observable. I find that the equilibrium can feature a "crisis of expertise," in which principals dismiss a competent expert's correct advice and rely only on public information. Notably, the crisis happens precisely when the quality of public information is low, and thus when the competent expert's knowledge is much needed. I discuss policy implications for alleviating the crisis.

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