Corporate short-termism has often been criticized because it could harm long-term performance. That is, managers arguably take actions that are favorable for them in the short-term at the expense of shareholders’ interest in increasing stock prices. Are corporate managers myopic when they do not invest sufficiently for the long term and hence short-termism is sub-optimal for shareholders? Or rather, can the behavior of managers be a result of equity value-maximization that crucially depends on firm characteristics, such as debt-equity ratio and growth prospects?
To answer these questions, we study the optimal contract between the shareholders and the manager of a firm that is funded with equity and risky debt. Shareholders choose value-maximizing debt and default policies. In addition, shareholders incorporate incentive cost and real option effects in designing an optimal contract based upon which the manager selects long-term effort (growth) and short-term effort (profit) in a multi-tasking environment. Because the manager’s efforts are unobservable, the manager needs to be exposed to the firm’s risk, which creates incentive costs for a risk averse manager with limited resources. However, risk makes the shareholders’ option to default more valuable, which we refer to as real option effect.
There are four important results. First, shareholders trade off the benefits of short-termism (current cash flows) against the benefits of higher growth, from long-term effort (future cash flows). Because shareholders split the latter with bondholders, they find it optimal to reduce investment in long-term effort and encourage the manager to focus on maximizing short-term profits. In contrast to conventional wisdom, short-termism can be optimal for the shareholders of firms that are not all-equity financed but also capitalized by significant amounts of debt.
Second, the optimal contracting solution reveals potential endogeneity problems. We find that firms with bright growth prospects optimally choose to focus on long-term growth, while firms with grim growth prospects optimally focus on the short-term. Hence, in equilibrium, one would observe that high growth firms are those that invest in the long-term. This does not mean that low growth firms should mimic the long-term approach of their high growth counterparts because it would be value-destroying for low growth firms to implement higher levels of long-term effort.
Third, the dynamic model enables us to quantify agency costs of debt, which we decompose into underinvestment and excessive short-termism. We calculate the reduction in total firm value due to debt overhang is about 1%, where up to one half of this reduction is due to excessive short-termism. Importantly, managerial short-termism is not detrimental to equity value but is, in fact, desirable, and it is bondholders the ones made worse-off as a result of excessive short-termism.
Finally, an extension considers a subset of shareholders with a shorter time horizon (higher discount rate) in control of the firm. Impatient shareholders find even higher short-term effort and even lower long-term effort optimal, which in turn reduces equity value for patient, regular shareholders and bondholders, who both employ the baseline, patient discount rate. A 1% point increase in the discount rate of impatient shareholders leads approximately to a reduction of 1% in equity value, 5% of debt value, and 2.5% of total firm value. Thus, our model predicts that a transfer of control to investors with shorter time horizons induces a sizable reduction in debt, and equity values, which is consistent with the conventional critique of short-termism.
To summarize, the paper shows that short-termism is not necessarily the result of myopic managerial behavior (as argued since the 1990s) but can in fact optimal for shareholders.