Modelling the Relation between Managers, Shadow Cost of External Finance and Corporate Investment

Abstract

This paper provides a theoretical framework for studying the impact of self-interested managers on the level of corporate investment. I extend the standard neoclassical model of firm value maximization to incorporate the effect of misaligned managers on corporate investment via a firm’s profit, adjustment costs of capital and shadow cost of external finance. Under some assumptions, commonly made by the relevant literature, the model shows that the intensity of agency conflicts between misaligned managers and outside shareholders affects a firm’s investment decisions generating either under or overinvestment with respect to a perfect capital market and driving a higher cost of external finance.