DP12690 Principle or Opportunism? Discretion, Capital, and Incentives

Author(s): Josef Falkinger, Michel Antoine Habib
Publication Date: February 2018
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Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12690

When should shareholders afford a manager the discretion to be opportunistic and when should they constrain him to be principled? We show that discretion is associated with lower powered incentives than is constraint: opportunism may put shareholder capital at risk; shareholder can lessen that risk by lowering the power of managerial incentives, thereby decreasing the manager's incentives to spurn principle for opportunity. We further show that the cost of capital plays a central role in favoring discretion over constraint: the use of capital constitutes an externality; when the cost of capital is low, the externality is of relatively little importance, and the manager is afforded the discretion to be opportunistic.