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Rev Fin 1994; 7:419-449
© 1994 the Society for Financial Studies

Article

Renegotiation and the impossibility of optimal investment

JC Persons
Ohio State University, Fisher College of Business, 1775 College Road, Columbus, OH 43210. USA

Abstract

In a model with asymmetric information and external equity financing it is impossible to achieve socially optimal investment because of renegotiation possibilities. The contractual solution suggested by Dybvig and Zender (1991) is not dynamically consistent - the manager's contract would be renegotiated, resulting in inefficient investment. Moreover, no other compensation contract that would induce the manager to invest efficiently survives renegotiation. Contracts that pay the manager based on the stock price, while producing suboptimal investment as in Myers and Majluf (1984), are robust to renegotiation.


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