DeMarzo, Peter M., Michael J. Fishman, Zhiguo He, and Neng Wang, 2012, “Dynamic Agency and the *q* Theory of Investment,” *The Journal of Finance, Vol. 67, No. 6 (2012)*, 2295-2340.

**Purpose:** To introduce an agency problem into the standard *q* theory of investment; to show that cash flow is not the best predictor of investment.

**Motivation:** A large body of literature uses cash flow to predict firm investment levels. This paper argues that a better proxy is “financial slack,” which is directly related to the agency problem.

**Model:**

- Productivity is a Brownian motion, and the agent controls the drift but not the volatility.
*w*=*W/K*is the agent’s total expected payoff per unit of capital, and must be high enough to incentivize the agent to maximize productivity.- The level of
*w*depends on λ, σ, and historical firm profitability.- λ is a measure of the extent of the agency problem.
- σ is the volatility of firm productivity.
- Past productivity raises or lowers
*w*, and the agent loses his job when*w*= 0. - A portion of
*w*is deferred, giving the agent a stake in continued firm success.

- Investor’s expected payoff per unit of capital,
*p(w)*, is a function of how much they pay the agent. - Average
*q*is total firm value per unit of capital stock, or*q*=_{a}*p(w)*+*w*. - Marginal
*q*, or*q*=_{m}*p(w)*–*wp’(w)*.- Firms invest when marginal
*q*is less than 1, so investment is a function of*w*. It follows that investment depends upon λ, σ, and past firm performance.

- Firms invest when marginal
- “Financial slack” equals
*w*/λ, and is the largest productivity shock the firm can suffer without changing agents. - The agent accumulates cash and available credit equal to the firm’s “financial slack,” then distributes excess income to shareholders.

**Conclusions:**

- Financial slack is a better predictor of investment than cash flow.
- Average
*q*is higher than marginal*q*because an increase in capital stock*K*reduces*w*, and hence reduces the agent’s [historically determined] incentives to maximize productivity. - Financial slack and profitability are substitutes in determining average
*q*. - When the firm is profitable,
*w*rises, the agent’s incentives grow, and return on investment increases.- Investment is serially correlated.

- The cost of incentivizing the agent leads to underinvestment in every state of the world.