RENEGOTIATION AND THE IMPOSSIBILITY OF OPTIMAL INVESTMENT

In a model with asymmetric information and external equity financing, it is impossible to achieve socially optimal investment because of ren egotiation possibilities. The contractual solution suggested by Dybvig and Zender (1991) is not dynamically consistent-the manager's contrac t would be renegotiated, resulting in inefficient investment. Moreover , no other compensation contract that would induce the manager to inve st efficiently survives renegotiation. Contracts that pay the manager based on the stock price, while producing suboptimal investment as in Myers and Majluf (1984), are robust to renegotiation.