Managerial Conservatism, Project Choice, and Debt

David Hirshleifer, Anjan V. Thakor
The Review of Financial Studies, Vol. 5 No. 3 (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' interest with those of bondholders, even though managers are hired of fired by shareholders. This effect opposes the familiar agency problem of risky debt that is imperfectly covenant-protected, wherin shareholders are tempted to favor excessively risky projects in oder to expropriate 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 influence by takeover activity, and how the adoption of anti-takeover measures affects a firm's investment policy and leverage choice.

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