Optimal Investment Rule in an Inefficient Financial Market

Abstract

This article studies the corporate investment decision problem faced by a manager whose compensation is pegged to the stock price at some future time (rewarding time)in a market that the stock price may deviate from its fundamental value. It provides an analytical solution on the optimal investment rule and finds that in certain cases the manager may not invest in a project even though its net present value is positive, or, the manager may invest in a project with a negative net present value. Hence both over-investment and under-investment problems can be explained in this unified model. This model also explains the empirical finding of Blanchard, Rhee and Summers (1993) that, given fundamentals, market valuations appear to play a limited role in affecting corporate investment decisions. In addition, the article finds that incentive mechanisms for managers which are related to the long-term stock prices can also lead to investment distortions. The results of this paper can reasonably explain the pattern of corporate investments, especially of venture capital investments.

Keywords: Capital budgeting, optimal rule, inefficient market

JEL Classification: G14, G31