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Rev Fin 1992; 5:437-470
© 1992 the Society for Financial Studies

Article

Managerial conservatism, project choice, and debt

D Hirshleifer1,z and AV Thakor
1 Anderson Graduate School of Management, UCLA, Los Angeles, CA 90024-1481, USA
Indiana University, USA
z Corresponding author

Abstract

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. Tbis effect opposes the familiar agency problem of risky debt that is imperfectly covenant-protected, wherein shareholders are tempted to favor excessively risk 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. We examine how the optimal choice of leverage from the shareholders' standpoint is influenced by takeover activity, and how the adoption of antitakeover measures affects a firm's investment policy and leverage choice.


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