Idiosyncratic Risk and the Manager

Compensating a manager with their own firm’s equity induces effort but also exposes the manager to firm-specific risk. Consequently, the discount rate of the undiversified manager differs from that of a diversified shareholder, resulting in a distortion in the optimal investment and financing policies chosen by the manager. We embed an agency conflict in a neoclassical model of the firm to investigate the quantitative effects of this distortion. In the calibrated model, the risk averse manager significantly underinvests, resulting in a long-run capital stock 7-12% below the shareholder’s optimal level. This represents a loss to shareholders of 1-2% of total firm value. Alternatively, this loss resulting from suboptimal investment policy can be viewed as the cost of inducing effort from the manager. Additionally, this friction helps to explain features of firmlevel investment, such as the positive skewness seen in the data. ∗Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213. Email: [email protected] †Wisconsin School of Business, University of Wisconsin, 975 University Ave, Madison, WI 53706 Email: [email protected]