A Test of Stulz's Overinvestment Hypothesis

Abstract

Abstract In a world with agency costs and asymmetric information, managers will have difficulty raising external funds since they have incentives to overinvest. Stulz argues that this leads to an optimal level of debt since this is one way to bond cash flows and reduce managerial discretion. However, unexpected cash flows cannot be so easily bonded. Thus, an implication of the Stulz hypothesis is that investment will be affected more by unexpected cash flows. Additionally, Stulz's hypothesis is most compelling for firms with low q ratios. Support is found for Stulz's hypothesis, and the support is strongest for low q firms.