NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Measuring Investment Distortions when Risk-Averse Managers Decide Whether to Undertake Risky Projects

Robert Parrino, Allen M. Poteshman, Michael S. Weisbach

NBER Working Paper No. 8763
Issued in January 2002
NBER Program(s):   CF

This paper examines distortions in corporate investment decisions when a new project changes firm risk. It presents a dynamic model in which a self-interested, risk-averse manager makes investment decisions at a levered firm. The model, calibrated using data from public firms, is used to estimate the magnitude of distortions in investment decisions. Despite potential wealth transfers from debtholders, managers compensated with equity prefer safe projects to risky ones. Important factors in this decision are the expected changes in the values of future tax shields and bankruptcy costs when firm risk changes. We also evaluate the extent to which this effect varies with firm leverage, managerial risk aversion, managerial non-firm wealth, project size, debt duration, and the structure of management compensation packages.

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Document Object Identifier (DOI): 10.3386/w8763

Published: Robert Parrino & Allen M. Poteshman & Michael S. Weisbach, 2005. "Measuring Investment Distortions when Risk-Averse Managers Decide Whether to Undertake Risky Projects," Financial Management, Financial Management Association, vol. 34(1), Spring.

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