Abstract
We develop a dynamic model of a public corporation run by risk-averse managers, who set investment, debt and payout policies subject to a governance constraint. Managers smooth rents but do not fully exploit interest tax shields. Managers with power utility set investment, debt and payout proportional to the firm's net worth, generating a constant (possibly negative) net debt ratio. With exponential utility, investment is independent of net worth, and debt is negatively related to net worth. Profitable firms become cash cows and unprofitable firms become highly levered. Financial decisions therefore depend nontrivially on the nature of managers' preferences.
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