Capital (mis)allocation and Managerial Incentives

Abstract: We study how firm investment policies and the allocation of capital are shaped by managerial incentives. Using the introduction of an accounting reform in the U.S. as a quasi-natural experiment that effectively shortened the horizon of managerial incentives for some firms (FAS 123R) we present reduced form empirical evidence on the relation between managerial incentives and firm investment policies. Based on a within-firm estimator that uses variation across investments with different durabilities, we find evidence that firms with more short-term incentives systematically shift their expenditures towards investments with a shorter durability and lower the durability of firms' capital stock. To rationalize the empirical findings and to quantify the impact of incentive distortions on output, investment and misallocation we then build a dynamic model of firm investments in which managers determine investment policies. We show that equity-based compensation contracts can induce managers to make investment decisions corresponding to quasi-hyperbolic time preferences such that there is systematic overinvestment in assets with shorter durability. The model illustrates that the relatively small deviations in managerial incentives caused by the accounting reform lead to substantial output and investment distortions within and across firms.