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.
