Managerial Conservatism, Project Choice, and Debt

David Hirshleifer and Anjan V. Thakor

Review of Financial Studies, July 1992


We show that the incentive for managers to build their reputations distorts firms’ investment policies in favor of relatively safe projects, thereby aligning managers’ interests with those of bondholders, even though managers are hired and fired by shareholders. This effect opposes the familiar agency problem of risky debt that is imperfectly covenant-protected, wherein shareholders are tempted to favor excessively risky projects in order to expropriate bondholders. Consequently, when managerial concern for reputation results in conservatism, it can actually make shareholders better off ex ante by allowing the firm to issue more debt. They examine how the optimal choice of leverage from the shareholders’ standpoint is influenced by takeover activity, and how the adoption of anti-takeover measures affects a firm’s investment policy and leverage choice.

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