Agency Cost of External Funding, Risk Taking and Investment

Abstract

In perfect capital markets a risk--neutral firm would invest until the expected marginal return equals the interest rate. Agency cost in financial contracting increase the shadow cost of external funding. It is often suggested that this wedge forces net worth firms to underinvest, the so called balance--sheet--effect. In this paper we argue that for a large class of agency problems firms may as well overinvest. We establish a robust though more subtle effect. Firms with low net worth, hence high cost of external financing, distort investment in order to reduce risk. Agency problems in financial contracting generate risk avoidance at the firm level even when all actors are risk neutral. This may explain why during major economic downturns firms and banks shun risks that could be accepted in better times.