Temporal Resolution of Uncertainty, the Investment Policy of Levered Firms and Corporate Debt Yields

Abstract

This paper attempts to link the agency literature (concerned with the fact that tensions between bondholders and shareholders may trigger suboptimal investment decisions) with the one dealing with temporal resolution of uncertainty (TRU). We consider here how the speed of resolution of the uncertainty characterizing the firm’s operations affects the risk-shifting behavior of a shareholder-aligned manager. It is assumed that investors are risk neutral and that the return on the risky technology is normally distributed. It is shown that the speed of TRU affects monotonically the extent of risk shifting as well as bond yields, even after optimal contracts mitigating deviations from the first-best investment policy have been written. In particular, the optimal investment-restricting covenant is endogenously characterized. Empirical implications are derived and discussed.