Measuring Investment Distortions when Risk-Averse Managers Decide Whether to Undertake Risky Projects

We create a dynamic model in which a self-interested, risk-averse manager makes corporate investment decisions at a levered firm with characteristics typical of public US firms. We examine the magnitude of distortions in those decisions when a new project changes firm risk and find expected changes in the values of future tax shields and bankruptcy costs to be important factors. We evaluate the extent to which these distortions vary with firm leverage, debt duration, project size, managerial risk aversion, managerial non-firm wealth, and the structure of management compensation packages.