Agency conflicts, financial constraints, and dynamic q-theory

Abstract

We develop a dynamic q-theoretic model where equity financing is uncertain and investment is delegated to a self-interested manager. We find that agency conflicts generate more volatile investments, and equity financing uncertainty can discipline managerial discretion and mitigate overinvestment issues. The disciplinary effect reduces future liquidation risk, thus weakening the manager’s hedging incentives. Furthermore, more prudent investment alleviates precautionary motives, and shareholders optimally reduce cash holdings to avoid managerial cash diversion. As a result, our finding provides a potential rationale behind the mixed empirical findings on corporate governance and cash holdings.