Agency and Optimal Investment Dynamics

We present a theory of the dynamics of a firm’s investment in the presence of imperfect capital markets and optimal long-term contracts. The class of imperfections that we consider involves the incentive problems that accompany external financing. The analysis is sufficiently general to encompass a range of such incentive problems. We derive a number of results regarding firms’ investment decisions, growth rates, dividends and survival rates. We show that these results arise largely from the general nature of optimal contractual arrangements, not from any particular model of moral hazard.