Journal of Financial Economics 110 (2013) 680–695

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Journal of Financial Economics

journal homepage: www.elsevier.com/locate/jfec

Boards, CEO entrenchment, and the cost of capital$

James Dow n
London Business School, Regent's Park, London NW1 4SA, United Kingdom

a r t i c l e in f o abstract

Article history: Existing research on chief executive officer (CEO) turnover focuses on CEO ability. This
Received 20 June 2012 paper argues that board ability is also important. Corporate boards are reluctant to replace
Received in revised form CEOs, as this makes financing expensive by sending a negative signal about board ability.
29 January 2013
Entrenchment in this model does not result from CEO power, or from agency problems.
Accepted 25 February 2013
Available online 28 August 2013
Entrenchment is mitigated when there are more assets-in-place relative to investment
opportunities. The paper also compares public and private equity. Private ownership
JEL classification: eliminates CEO entrenchment, but market signals improve investment decisions. Finally,
G34 the model implies that board choice in publicly listed firms will be conservative.
G32
& 2013 Elsevier B.V. All rights reserved.

Keywords:
Managerial entrenchment
Cost of capital
Corporate boards
CEO turnover

1. Introduction decisions that are not shareholder-value maximizing (Rajan,

When does a board replace an under-performing chief
executive officer (CEO)? An established body of research
studies the proposition that CEOs are overly secure in their
jobs (including Shleifer and Vishny, 1989; Bebchuk and
Fried, 2003; Casamatta and Guembel, 2010, and other
papers discussed below). Warren Buffett, in his 1988 letter
to shareholders, commented: “The supreme irony of busi-
ness management is that it is far easier for an inadequate
CEO to keep his job than it is for an inadequate subordi-
nate. . . If the board makes a mistake in hiring, and
perpetuates that mistake, so what?” Indirect evidence for
entrenchment is to be found in empirical studies suggest-
ing that CEOs often take capital allocation and acquisition
☆
I thank Patrick Bolton, Elena Carletti, Paul Coombes, Francesca
Cornelli, Alex Edmans, Julian Franks, Vito Gala, Piero Gottardi, Christo-
pher Hennessy, Igor Makarov, Ailsa Roell, Luke Taylor, Paolo Volpin, and a
referee for comments. A previous version of this paper was entitled
“Board incentives and CEO turnover”.
n
Tel.: þ44 207 000 8260.
E-mail address: jdow@london.edu
Servaes, and Zingales, 2000; Lang and Stulz, 1994; Schoar,
2002). If shareholders could control their companies effec-
tively, they would fire CEOs who do not maximize value.
As a result, takeovers, despite their enormous transactions
costs, are often viewed as a mechanism for replacing
top management (Shleifer and Vishny, 1986; Grossman
and Hart, 1980). Taylor (2010) is an empirical study that
attempts to measure entrenchment directly. He estimates
that boards behave as if firing the CEO has a deadweight
cost of 5.9% of the firms' assets, and that the majority of this
amount represents an implicit disutility to board members
that is not a true cost to shareholders.
Existing research on CEO turnover and performance
focuses on CEO ability (e.g., Mikkelson and Partch, 1997;
Huson, Malatesta, and Parrino, 2004; Jenter and Kanaan,
2006), although mostly not from the viewpoint of asym-
metric information.1 In this paper, I argue that the ability
1
Most empirical research on turnover assumes that variation in
performance reflects variation in CEO ability (as well as, possibly,
variation in CEO effort) and that firing reflects replacement of low ability
CEOs. This is explicit in Jenter and Kanaan (2006) and implicit in

0304-405X/$ - see front matter & 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.jfineco.2013.08.009
 J. Dow / Journal of Financial Economics 110 (2013) 680–695
of the board is also important. I model entrenchment given
that the CEO firing decision is taken by the board, which
remains in place after the CEO is gone and cares about how
the market perceives its decision. The board cares because
it is not only CEOs who differ in ability. Boards also differ.
Therefore, the bad news that is conveyed by firing does not
just attach to the departed CEO. This bad news has
implications for the ability of the firm to raise external
finance. Knowing this, the board is reluctant to fire the
CEO, even in the absence of any board agency conflicts.
To illustrate, consider the example of a small company
with high growth potential that will need large amounts of
additional financing. Suppose the board discovers that the
CEO is under-performing: he could be neglecting his job,
he might display poor judgment or in an extreme case, he
could even be guilty of fraud. The gut response is to fire.
But the market would likely conclude that the initial bad
news that the CEO needs to be replaced has negative
implications for the company's future after he has left.
After all, if the board appointed the wrong CEO once,
maybe it would do so again. The firing decision is not just a
reflection on the departing CEO. It also reflects badly on
the board itself, and hence, on the firm's prospects.2 If the
firm needs to raise external funding, the terms of the
financing will be worse. Intuitively, the outcome could be
that the terms are so disadvantageous that it is impossible
for the firm to raise funding for the project. In the model,
this, is in fact, the only possible outcome in equilibrium for
a small firm with no assets in place. For a larger firm with
existing assets, there is a trade-off because assets in place
mitigate the lemons problem of issuing new equity follow-
ing CEO replacement.
In the existing literature, a number of different expla-
nations have been given for CEO entrenchment. First, CEOs
could be able to choose projects tactically so as to make
themselves difficult to replace (Shleifer and Vishny, 1989).
Second, shareholders simply might not have much control
over contracting with the CEO, as is assumed in principal
agent theory. Bebchuk and Fried (2003) argue that a
hypothesis of ‘managerial power’ is a better description
of corporate governance than principal-agent theory (for
example, Bebchuk and Kamar, 2010 find evidence that
management can manipulate the corporate charter at
shareholders' expense). Third, in certain principal-agent
problems, it can be optimal for the principal to commit to
(footnote continued)
Mikkelson and Partch (1997). In contrast, most theoretical models focus
on incentive provision for CEOs, hence, they assume that CEOs need to be
incentivized to take optimal actions. In these models, firing is used to
provide incentives rather than to select on ability and many of these
models do not assume any variation in CEO ability. Huson, Malatesta, and
Parrino (2004) argue that empirical evidence supports the notion that
performance variation associated with firing mostly reflects variation in
ability instead of than variation in effort.
2
In this example, reputation attaches specifically to the board. This
narrow interpretation is not necessary. One could equally interpret the
firing as a negative signal about the firm, since an organization that
allows an incompetent CEO to be appointed could be defective in other
ways. For example, if the CEO is an internal hire, firing sends a bad signal
because it reveals that an incompetent manager was able to thrive and be
promoted within the organization. The main focus of this paper is on
boards, however.
681
entrenching the agent, and the owner–CEO relationship has
particular features that make this apply (for example, Gorton
and Grundy, 1996; Dow and Raposo, 2005; Casamatta and
Guembel, 2010).
This paper also argues that entrenchment can arise in
equilibrium, but the explanation here differs by being
specific to a situation with the CEO, the board (or firm),
and the market. The explanation depends on the signal given
to the market by the firing decision and how this feeds
back into the optimal firing rule. In contrast, Gorton and
Grundy (1996), Dow and Raposo (2005), and Casamatta
and Guembel (2010) give explanations that have a natural
application to CEOs, but they could also apply to other
employees in situations where there is no interaction with
market financing.
Finally, while most of the literature views entrenchment
as either ex post costly or ex ante suboptimal, Fisman,
Khurana, and Rhodes-Kropf (2004) argue that entrench-
ment is valuable because it prevents CEOs from being
suboptimally fired by misguided shareholders.
If boards are reluctant to fire because of the negative
signal firing sends, then firing should cause a drop in share
price. Huson, Malatesta, and Parrino (2004) find that firing
has a positive effect of about 2% (some other studies show
different results, including Jenter and Kanaan, 2006. See
Section 6 for a discussion). Can this be consistent with the
model in my paper? The model can readily be reconciled
with a small, but negative, average announcement effect,
which would arise if the board's private signal is frequently
followed by the market also learning the signal on CEO
ability. Then, the board would always fire the CEO after
receiving a public signal but would often not fire after
receiving the private signal and, therefore, many sackings
(those following the public signal) would be uninformative
for stock prices. The average response would be negative but
could be arbitrarily small if most private signals do not result
in firing (as predicted by the model of this paper) while the
frequency of public signals is high. On the other hand, a
positive announcement effect requires an explanation that is
different from, although not necessarily incompatible with,
the effects studied in this paper. Various explanations are
possible including (i) that the market had previously learned
that the CEO should be replaced, but the board has only just
learned it; (ii) that both the market and the board have
previously learned that the CEO should be replaced, but the
market did not know the board would succeed in firing the
CEO at this time; or (iii) that the market had not previously
learned the CEO should be replaced, but firing simulta-
neously sent a positive signal about the board and a negative
signal about the CEO (Hermalin and Weisbach, 1998, argue
that if some boards are more independent, in the sense that
they have a lower cost of monitoring the CEO, and if the
market does not know how independent they are, firing
could be a good signal). Explanations (i) and (ii) could be
combined with the explanation given in this paper to predict
the observation of positive announcement returns around
CEO firings.
An important question in financial economics is: which
kinds of firms should be publicly listed, and which should
be privately owned? This paper shows that separation of
control and financing has a cost because of the ongoing
682 J. Dow / Journal of Financial Economics 110 (2013) 680–695
need to send positive signals to the markets that provide
finance. A deep-pockets owner can avoid this cost. Private
owners with secure funding can take decisions on CEO
replacement without worrying about the signal. Hence,
one implication of this analysis is that privately owned and
financed firms are more willing to fire their CEOs.3 While
the board of a public firm often retains a CEO it knows to
be worse than the replacement, a private firm simply
replaces the CEO whenever the replacement seems better.
But private companies are not necessarily superior,
because the market can sometimes produce information
that the CEO does not have. I analyze this trade-off to
determine when a company that is privately owned and
financed is superior to a public corporation. One implica-
tion is that firms with valuable assets in place are, other
things equal, less likely to choose private equity.
The model can be extended in several directions. I show
that firms are better off if they are conservative in making
board appointments. Board members with extensive
experience could be preferred over people with little prior
experience whose skill as board members appears high,
but is not known with much certainty. I then show that the
model's results are robust with respect to a couple of
alternative assumptions. Alternative board objective func-
tions such as empire building or career concerns yield
similar results. This is arguably not surprising in the sense
that these objectives are different from shareholder value
maximization, while the main result of the paper — that
entrenchment and an ex post suboptimal firing rule can
result from a board that maximizes shareholder value — is
less immediate. Also, similar results to the main model
follow if the value of assets in place is correlated with new
project payoff (they are assumed uncorrelated in the main
analysis), although the analysis is more complex. Next,
I discuss the choice between debt and equity, while the
main part of the paper assumes equity financing only.
The structure of this paper is as follows. In Section 2
I set out the model and, as a benchmark, derive the first-
best firing rule. Section 3 states the main result: the board
does not fire the CEO unless its estimate of his ability falls
below a threshold that is strictly lower than the first-best
threshold for firing. Section 4 compares public and private
companies. Section 5 is a discussion of assumptions and
extensions. Section 6 presents a discussion of the model's
empirical predictions. These empirical implications con-
cern, in particular, the relation between CEO entrench-
ment, assets in place, and investment needs. Section 7
concludes.
2. The model
I assume that CEOs are appointed and fired by a board
and that finance for a new project is raised from the
market in the form of new equity. The sequence of events
is as follows:
First, the old CEO is appointed.
3
Some private equity firms could be concerned that the decision
taken on an individual investment will subsequently affect their ability to
attract financing. Hence, this argument will not apply to small private
equity firms that do not have an established track record.
Second, the board receives a signal about the CEO's
ability. This could be interpreted as any private signal the
board receives about the CEO's ability. The signal is
represented by a number p, which is the probability that
the project will succeed with the old CEO. p is continu-
ously distributed with EðpÞ ¼ 12 and has support equal
to [0,1].
Third, the board decides whether to continue with the
old CEO or to fire and replace him. The chance of success
with the new CEO is positively correlated with the old
CEO's ability. I assume the board fires the old CEO if the
signal on his ability falls below a threshold p′. This includes
as special cases p′ ¼ 0 (the CEO is never fired) and p′ ¼ 1
(the CEO is always fired).
Fourth, the firm tries to raise money from the market to
finance the cost K of investing in the project. If the
investment is made, it is financed by issuing new equity
at fair value, given the information available to the market
(i.e., the market for external financing is competitive). The
money raised must be invested in the project, and cannot
be used for any other purpose.
Finally, the payoff on the project is realized. This is
either 0 (failure) or 1 (success). The firm also has assets in
place whose payoff V is realized at that time. Because the
terminal value of the firm takes two possible values, the
financing could equivalently be described as debt. I assume
the assets in place V are illiquid and nonverifiable so they
cannot be used to finance the project, for example, by
being used as collateral (this is also assumed in Myers and
Majluf, 1984). I assume that V is a constant. Appendix A.3
contains a generalization to the case in which V is a
random variable whose payoffs can be correlated with
the new project's.
An important assumption concerns the chance of
success with new manager. Boards' abilities to pick man-
agers vary, so the market makes inferences about their
ability from their past decisions (an alternative interpreta-
tion could be that a board that picked a bad manager is
weak and this directly lowers expected firm value). So,
the chance of success of the new CEO is increasing in the
chance of success of the old CEO. To be specific, I assume
that if the old CEO is fired, the chance of success with the
new CEO is

π


PrðNew CEO succeeds
Old CEO would succeedÞ ¼ 1 ;
2

π


PrðNew CEO succeeds
Old CEO would failÞ ¼ ð1Þ
2
for some parameter π o 1 (low π means that all of the
variation in ability is due to the board). This assumption is
explained in the next subsection.
I assume that


π 2 þð1πÞEðp
p o 12 Þ o K o 12;
1
ð2Þ
which, as I show in Section 2.2, means that the project is
good enough to be worth investing in for an average
signal, but not so good that it is worth investing in if it is
known that the signal is below-average.
I assume that the board maximizes the value of the
existing equity, as in Myers and Majluf (1984). Section 5.2
contains a discussion of this assumption and shows that
 J. Dow / Journal of Financial Economics 110 (2013) 680–695 683

the result is robust to alternative assumptions based on 1

empire building and career concerns.

2.1. Modelling CEO ability and board ability

0.75

Assumption (1) captures the idea that learning about

board ability means the market's expectation of a replace-

Ability
ment CEO is correlated with the ability of the incumbent 0.5
CEO. For most of the analysis, it is sufficient to use this
assumption without being more specific. However, these
conditional probabilities can be derived from a model of
the underlying process of CEO selection. The CEO can be 0.25
modeled as a random draw from a population of CEOs
with different abilities, in which the population that the
board selects from corresponds to the board's ability.
An extreme case is when all the variation in CEO ability 0
is due to the individual CEO, and board ability is fixed. In 0 0.25 0.5 0.75 1

this case, if the CEO is replaced, the new CEO is just an
independent, identically distributed (IID) draw from the
same population. The opposite extreme is the case in
which all the variation in CEO ability is caused by variation
in board ability. In this case, if the CEO is replaced, the
board appoints a replacement with exactly the same
ability.
Between these two extremes, the intermediate cases
can be represented by a probability π that the CEO is an IID
draw from the same distribution as the old CEO and a
probability ð1πÞ that the CEO has exactly the same ability
as the old CEO (assume the board does not know the
realization of this random variable). π-1 represents the
case of variation in CEO ability only, in other words all
boards appoint CEOs drawn from the same distribution of
abilities. Each appointment, made by any board, is an IID
draw from this distribution. π-0 represents the case of
variation in board ability only, in other words all the
variation in CEO ability is explained by the board's ability
to pick CEOs. A given board always appoints CEOs of equal
ability, but this varies across boards and the market does
not know the ability of the board. This generates the
probabilities shown in Eq. (1). Assuming the new manager
has a probability π of being a fresh draw from a distribu-
tion with mean 12, and probability 1π of being the same as
the old manager, then

the market cooperate to maximize value. If the CEO is
PrðNew CEO succeeds
Old CEO would succeedÞ
 
1 π
¼π þð1πÞð1Þ ¼ 1 ð3Þ
2 2
and

unaffected by the decision. If the CEO is retained, the
PrðNew CEO succeeds
Old CEO would failÞ
 
1 π
¼π þð1πÞð0Þ ¼ : ð4Þ
2 2
Ability of existing CEO
Existing CEO New CEO
Fig. 1. The ability of the new chief executive officer (CEO) is correlated
with the ability of the old CEO. The figure shows the ability of the new
CEO (dashed line) and the old CEO (solid line) as a function of the ability
of the old CEO. See Eq. (3). The graph is drawn for π ¼ 1=2.
distribution, the replacement likely would be too. The nega-
tive consequences of this signal can outweigh the benefits of
replacing a CEO with one who is expected to be better. For
the intermediate case of π ¼ 12; Fig. 1 illustrates the correla-
tion between the ability of the old CEO and the ability of the
replacement CEO.
The results in this paper do not depend on the
distribution of p so long as Eqs. (1) and (2) hold, but the
uniform distribution is used as an example to illustrate
some of the results. In this example, the ability of the old
CEO is U[0,1], and the new manager has probability π of
being a fresh draw from U[0,1], and probability 1π of
being the same ability as the old manager.
2.2. First-best investment decisions
Consider as a benchmark the first-best, that is, the
optimal firing and investment decisions if the board and
fired, the payoff from the project is
 π
π π
p 1 þ ð1pÞ K ¼ pð1πÞ þ K: ð5Þ
2 2 2
This excludes the value of any assets in place, which are
payoff is
pK; ð6Þ

In the case of variation in CEO ability only ðπ ¼ 1Þ, the so the first-best rule is to fire if pð1πÞ þπ=2K 4 pK or
board firing the CEO does not send any signal to the market p o 12. Further, the question of when the company should
about the ability of the next CEO. In the case in which π is invest in the project can be investigated. If the CEO is
close to zero and the board's signal on CEO ability is very low, fired, the payoff if the company invests is positive if
the board would like to replace the CEO but, if the market pð1πÞ þ π=2K 40 or
knows it follows this rule, then firing sends a negative signal π
to the market about the ability of the replacement CEO. K
p4 2 : ð7Þ
In this case, if the incumbent CEO is from the lower tail of the 1π
684 J. Dow / Journal of Financial Economics 110 (2013) 680–695
Conditional on the board's signal of CEO ability being
below average, the expected value of investing in the
project (and replacing the CEO) is Eðp∣p o 12Þð1πÞ þ
π=2K, so condition (2) is the statement that this is
negative net present value (NPV). If the CEO is not replaced,
conditioning on this event, the NPV is even worse.
To compute the value of the project when the first-best
firing and investment policies are followed, note that for
p oðKπ=2Þ=ð1πÞ, the payoff is 0; for ðKπ=2Þ=ð1πÞ
o p o 12 the payoff is as given in Eq. (5); and for p 4 12, the
payoff is as given in Eq. (6). Written more compactly, this
is maxf0; pð1πÞ þ π=2K; pKg and the ex ante payoff
(before learning p) is
n o
π
E max 0; pð1πÞ þ K; pK : ð8Þ
2
Example 1. Value of the project under the first-best policy
when p is uniformly distributed, p  U½0; 1.
If p is uniform the ex ante payoff is
Z 1 n o
π pectedly did see the CEO being retained? It is reasonable to
max 0; xð1πÞ þ K; xK dx
0 2
Z 1=2 Z 1
π
¼ xð1πÞ þ K dx þ xK dx
ðKπ=2Þ=ð1πÞ 2 1=2
πð4K3Þ þ 4ðK1Þ2
¼ :
8ð1πÞ
Condition (2) reduces to ð1 þ πÞ14 o K.
3. Main result: the board is lenient in firing the CEO
To aid intuition, I start by considering the case in which
the firm is a start-up with no existing assets. In this
extreme case, I show an extreme result: the board will
never fire the CEO and the firm will always invest, even
when the signal it receives about his ability is so bad that it
would be better not to invest in the project at all. Following
this result I consider the general case with assets in place.
Proposition 1. If the board's objective is to maximize the
value of old equity, and there are no assets in place, then the
unique equilibrium is for the board never to fire the CEO and
the firm always to invest.
Proof. First, to see that this is an equilibrium, consider the
market's beliefs if the CEO is never fired. When the
company tries to raise financing for the project, the market
infers nothing new about the CEO's ability. It just expects
the CEO to be of average quality. Because the project is
ex ante positive NPV ðEðpÞ ¼ 12 and K o 12Þ, it should be
possible to finance the project with new equity from the
market (priced competitively to return zero NPV) and
improve the NPV of the old equity. This can be done by
issuing the market with a share α of the total equity such
that α PrðSuccessÞ ¼ K, so
K π
α¼ ¼ 2K;
EðpÞ
and the old equity is worth
K 1
EðpÞð1αÞ ¼ EðpÞð1 Þ ¼ K; ð11Þ
EðpÞ 2
which is just the ex ante NPV of the project. But what if the
market, unexpectedly, sees the CEO being fired? It is
reasonable to suppose this is not a good signal of CEO
quality, therefore it lowers the market's expectation of p,
so the market in response would either demand more
equity, or refuse to finance the project at all. In either case,
the board, acting to maximize value for existing equity
holders, would be worse off. This completes the argument
showing that no firing is an equilibrium.
Could anything else happen in equilibrium? First, ima-
gine the opposite situation in which the CEO is always
fired. In this case, the market would also make no
inferences from firing and so, because the unconditional
expected chance of success with a new CEO is the same as
with the old one, the project could be financed with
exactly the same equity issuance, again creating 12K of
value for the old shareholders. But imagining this to be an
equilibrium, what should the market conclude if it unex-
infer this is a good signal, in which case the market would
accept a lower equity share for financing the project, and
the firm would be better off. This can, therefore, be ruled
out as a possible equilibrium.
Next, imagine an equilibrium in which the CEO is
ð9Þ sometimes fired and sometimes retained, depending on
the board's information. Suppose there is a threshold
p′ A ð0; 1Þ so that the CEO is fired if the board observes
p o p′ and is retained if p 4p′ for 0 o p′ o 1. Can this be an
equilibrium?
If so, the market's expectation of the project's chance of
success depends on whether the CEO is fired. When he is
not fired, it is Eðpjp 4p′Þ. Because this exceeds the uncon-
ditional expectation EðpÞ, the market is willing to finance
the project and the equity issuance required, K=Eðp∣p 4 p′Þ,
is less than in the equilibrium where the CEO is always
retained [Eq. (10)]. When he is fired, the market's expecta-
tion of the chance of success is Eðπ=2 þ pð1πÞjp o p′Þ,
which might or might not be enough to make the project
positive NPV and, hence, make the market willing to
finance it in exchange for a big enough equity share.
If the market would not finance it following firing, then
clearly the board would never fire, so this would not be an
equilibrium. If the project would still be financed following
firing, the equity share demanded by the market would be
larger than following no firing. For very low p, it might
make sense for the board to fire the CEO because the higher
equity issuance would be offset by a much better CEO.
But what about when p is right at the borderline, p ¼ p′?
Equilibrium requires indifference. Consider the payoffs in
more detail. The equity issuance when the CEO is fired would
be αF ¼ K=ðπ=2 þ ð1πÞEðpjp op′ÞÞ; when he is retained, it is
the lower amount αR ¼ K=Eðpjp 4 p′Þ. If the board is indif-
ferent at p′ between firing and retaining the CEO, it must be
that firing, which is more costly in terms of dilution, is offset
by a higher chance of success:

ð10Þ þ p′ð1πÞ ð1αF Þ ¼ p′ð1αR Þ; ð12Þ
2
 J. Dow / Journal of Financial Economics 110 (2013) 680–695
which implies p′ o 12 (see Fig. 1 in Section 2.1 and the
discussion in Section 2.2). But, conditioning on p′ o 12, the
project is negative NPV given the information available to the
market [see condition (2)] and, therefore, cannot be financed
by issuing even 100% of the equity to the market. Therefore,
this could not be an equilibrium. □
Firms generally have assets in place as well as new
investment opportunities, so I now turn to the main result
of the paper which considers the case in which V 4 0: The
CEO is fired by the board if its signal of his ability falls
below a threshold p′. Consider how p′ is determined and
whether the project gets financed if the CEO is fired. If the
project is funded, then in equilibrium the market con-
tributes funding K in exchange for a fraction of equity α
whose expected value equals the funding raised:
αðV þ PrðSuccessÞÞ ¼ K; ð13Þ
where the probability of success is updated by the market,
depending on whether the CEO has been fired. If the CEO is
retained, the market infers that p 4 p′, so the market's
estimate of the chance of success is Eðpjp 4 p′Þ. If the CEO
is fired, the market is pessimistic about the new project and
it demands a higher equity share to compensate. If the board
observes a signal p, the chance of success with a replacement
CEO is π=2 þ pð1πÞ, so the market's estimate of the chance
of success following firing is π=2 þ Eðpjp o p′Þð1πÞ. For ease
of notation, define
Exþ  Eðpjp 4 xÞ ð14Þ
and
E
x  Eðpjp oxÞ: ð15Þ
Then
K
αF ¼ π ð16Þ
V þ þ E
p′ ð1πÞ
2 ∂x ðVK þ Exþ Þ2 ∂x
and
K note that f is continuous, strictly positive (because Exþ Z
αR ¼ þ o αF ð17Þ
V þEp′
give the equilibrium amounts of equity dilution required to
finance the project, if the project is funded in equilibrium
(where the subscript F stands for fire and the subscript R
stands for retain). I start by investigating whether the project
is funded in equilibrium if the CEO is fired.
Can a negative-NPV project be financed by the market?
Suppose that, conditional on a decision by the board (to fire
or retain the CEO), the project is funded in some set of states
of the world, p A P, where P  ½0; 1 (for example, it could be
the CEO is fired whenever p o 12, and the project is funded
when he is not fired; this is represented by P ¼ ½12; 1). Then
the expected NPV of the project, conditional on p A P, must
be (weakly) positive. In other words, it is impossible, in
equilibrium, for the market to fund a project it believes to be
(strictly) negative NPV. The reason is simple: this is just a
corollary of the no-trade theorem (Milgrom and Stokey,
1982; Rubinstein and Wolinsky, 1990).4
4
Let X be the existing shareholders' expected gain, conditional on
p A P, from the transaction of raising finance and carrying out the project.
685
Consider whether firing can be followed by investment.
In equilibrium, when the board observes a signal of CEO
ability that is just borderline, p′, it must be indifferent
between firing and retaining the CEO. Hence, if firing is
followed by investment,
 π 
ð1αF Þ V þ þ p′ð1πÞ ¼ ð1αR ÞðV þp′Þ: ð18Þ
2
Because dilution following firing is greater ðαF 4αR Þ, the
chance of success following firing, π=2 þp′ð1πÞ, must be
correspondingly higher, π=2 þp′ð1πÞ. This implies that
the signal about the original CEO is below average, p′ o 12,
which, in turn, means that the project is negative NPV
conditional on the market's information. Thus, the project
cannot be financed in equilibrium, once the CEO has been
fired, regardless of how valuable the assets in place are.
Because in equilibrium firing is not followed by invest-
ment, the threshold value for firing must satisfy
V ¼ ð1αR ÞðV þ p′Þ; ð19Þ
so
V
p′ ¼ V ¼ f ðp′Þ; ð20Þ
1αR
(intermediate steps in the derivation are in Appendix A.1)
where
KV
f ðxÞ  : ð21Þ
VK þExþ
This equation has a unique fixed point for any distribution of
p, described graphically by the intersection of f with the 451
line (see Fig. 2). The function f also provides an algorithm for
finding the solution: given pn, define pn þ 1 ¼ f ðpn Þ. Unique-
ness of the solution p′ is implied by the fact that f slopes
down and, hence, cannot intersect more than once:
∂f KV ∂Exþ
¼ o0: ð22Þ
To show the solution p′ exists and is interior, it is sufficient to
EðpÞ ¼ 12 4 KÞ; and strictly less than one (because f is decreas-
ing and f ð0Þ o K o 1Þ: f ð0Þ o K because f ð0Þ ¼ KV=ðVK þ
1=2Þ oKV=V ¼ K. This also implies the solution p′ o 12,
because f is decreasing and must, therefore, intersect the
451 line below f ð0Þ and f ð0Þ o K o 12.
Now, in first-best the CEO would be replaced whenever
p o 12. In equilibrium, the threshold for replacing the CEO is
lower than this, so the replacement policy is lenient. The
distortion is more extreme when assets in place are of low
(footnote continued)
Let Y be the market's expected gain, conditional on the same event, from
the same transaction. Let Z be the expected NPV of the project, condi-
tional on the same event. Then, X þ Y ¼ Z. Because the market is willing to
finance the project in equilibrium, conditional on the event, it must be
that Y Z 0 (in fact, as I assume the market is competitive, Y ¼ 0). Because
the firm is willing to raise finance for the project, conditional on the
event, it must be that X Z 0 (otherwise, it could simply stop trying to
raise funding conditional on this event). Therefore, it must be that
Z ¼ X þ Y Z 0. (The no-trade literature assumes that trades do not take
place if it is common knowledge they are not Pareto improving. Because
of the simple informational structure of this model, if all agents know the
trade is not Pareto improving, it is common knowledge that it is not
Pareto improving.)
686 J. Dow / Journal of Financial Economics 110 (2013) 680–695

1 If p is uniform, then Ep′þ ¼ ð1 þ p′Þ=2, so that

KV
f ðxÞ ¼ : ð24Þ
0.8
1 þx
VK þ
2
The solid line in Fig. 2 illustrates the equilibrium value of p′
0.6
(setting K ¼3/8 and V ¼1) and the effect of varying V up
f(p) (dashed line) or down (dotted line).
A closed-form solution for p′ can be derived from
0.4
Eq. (24)
1 þ p′
0.2 0 ¼ KV þp′ðVKÞ þ p′ ; ð25Þ
2
so
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
0    
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1 1 2
p′ ¼  VK þ þ V 2 þ K þV ð26Þ
p 2 2
Fig. 2. Equilibrium value of the firing threshold p′. The equilibrium value (the details are given in Appendix (A.1)). From Eq. (8), the
of p′ is determined where the function f ðpÞ defined in Eq. (21) intersects first-best value of the project, excluding assets in place V, is
the 451 line. The solid curve is drawn for the uniform distribution of n π o
ability setting V ¼1, K¼ 3/8, and π ¼ 1=2. The graph shows the effect of E max 0; þ pð1πÞK; pK : ð27Þ
varying V up (dashed line) and down (dotted line). 2
In contrast, the value with market financing is as follows.
Because the equity issued to the market is fairly priced, the
value. However, even when assets in place are very existing equity holders give away an equity share that is on
valuable, the leniency remains. As V-1, the firing thresh- average worth K. So the value of the old equity (again
old does not converge to the first-best value p′ ¼ 12. Instead, excluding the assets in place) is
it remains stuck below K, which is lower than 12. In other
þ
words, the firing threshold is bounded away from the first- Prðp 4 p′ÞðEp′ KÞ: ð28Þ
best value, however valuable the assets in place. This can
In particular, if p is uniform, then the value with market
be seen by noting that the intersection between f and the
financing is
451 line must occur below K because f ð0Þ oK, and f is  
decreasing. 1 þp′
ð1p′Þ K
The comparative statics for the threshold p′ with respect 2
0 sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi1
to V, showing that the solution p′ is strictly increasing in V,    
1 1 @ 1 1 2
can be derived by considering ¼ KKV þ V þ K V þ V 2 þ K þ V A;
2 2 2 2
∂f ðVK þExþ ÞKKV ðExþ KÞK ð29Þ
¼ þ
¼ 40: ð23Þ
∂V ðVK þ Ex Þ 2
ðVK þ Exþ Þ2
using Eq. (26), while from Eq. (9), the first-best value is
Hence, p′ defined by the intersection f ðxÞ ¼ x must also be πð4K3Þ þ 4ðK1Þ2
strictly increasing in V. Intuitively, with lower assets in place, : ð30Þ
8ð1πÞ
there is more of a lemons problem from equity issuance.
A bigger fraction of the firm has to be offered to outside The loss from market financing is largest when V is
investors, and this equity offering is subject to a lemons small, causing a large distortion in the firing rule.
problem. The above discussion is summarized in Pro-
position 2: 4. Publicly listed firms versus private equity

The separation between financing (ownership) and the

Proposition 2. Assume the board acts to maximize the value
of existing equity. The CEO is fired if the board's signal of his
ability p falls below a threshold p′. No investment is made
following firing. p′ is uniquely determined. The CEO is fired
less often than in first-best: p′ o 12. The more valuable the
assets in place V, the more efficient the firing decision: the
threshold p′ is strictly increasing in V. When assets in place
are small, the CEO is hardly ever fired: as V-0, p′-0. But
even when assets in place are very valuable, the CEO is fired
less often than in first-best: as V-1; p′-K o 12.
firing decision (control) has negative consequences,
including the ones highlighted in my model. But markets
also have benefits. In particular, the market has the
advantage that it can produce additional information
about the project (Hayek, 1945).5 So publicly listed firms
have both advantages and disadvantages compared with
privately financed firms. A private firm does not have to
worry about the signals sent by its decisions, but it does
not benefit from the information production given by the

5
Other advantages include having a stock price to motivate man-
Example 2. Illustration of the solution for the case of the agers (Holmstrom and Tirole, 1993). In Dow and Gorton (1997), the
uniform distribution. market produces additional information as well as motivating managers.
 J. Dow / Journal of Financial Economics 110 (2013) 680–695
stock market. The model developed in this paper can be
extended to explore this trade-off.
The question of when to go public and when to remain
(or go) private seems important, but only a relatively small
literature exists on the choice between public and private
(stock market-listed) ownership. Pagano and Roell (1998)
consider a trade-off between liquidity and monitoring.
Benninga, Helmantel, and Sarig (2005) consider the trade-
off between the higher valuations of public firms as a
result of diversified outside investors and private benefits
of control of privately owned firms.
The assumption here that the market provides a signal
that increases firm value is related to the literature on how
stock prices can improve investment decisions and hence
increase firm value. Leland (1992), Boot and Thakor (1997),
and Dow and Gorton (1997) are among the theoretical
analyses of this feedback effect, which has been shown
empirically by Baker, Stein, and Wurgler (2003), Luo
(2005), and Chen, Goldstein, and Jiang (2007).
There are different types of privately owned firms.
Venture capital-funded start-ups, or previously listed firms
that are taken private, can be managed with the objective
of raising additional financing, reselling or listing the firm.
While some private equity funds are well financed, others
need to secure ongoing additional funding. This affects the
owners' incentives, making them care more about market
perception. Here, I simply portray the privately owned
firm as being unconcerned with signals sent to possible
future new owners or financiers. This is appropriate when
the owner has a long time horizon and does not need
additional outside financing within that horizon or when
he has a solid reputation that is not significantly affected
by new signals.
I compare a public firm as modeled above, but where
an additional signal is generated by the market when the
firm raises external finance, with a private firm whose
owner provides finance and takes the firing decision, but
who does not receive the additional market signal.
While, in reality, markets aggregate the signals of many
dispersed agents, for convenience I model the aggregate
signal directly. This can be viewed as the average of many
individual signals. I assume that, with probability q, the
market learns the actual outcome before investing. This
signal arrives after the firing decision. All other assump-
tions are unchanged from Section 2. Following the decision
to fire or retain the CEO, if the market learns that the
project will succeed, the firm issues an equity share of
α ¼ K=ð1 þ VÞ: If the market learns the project will fail,
there is no investment. If the market does not receive a
signal, the market decides whether to invest based on the
firing or retaining decision, exactly as in the previous
analysis. Using the same arguments as before, retaining
the CEO leads to investment but there is no investment
following firing. The equity issuance is as before, αR ¼ K=
þ
ðV þ Ep′ Þ [see Eq. (17)]. p′ is again determined by an
indifference condition. If the CEO is fired, the board's
payoff is
qp′ðV þ 1KÞ þ ð1qÞV:
This payoff is derived as follows. If there is a signal
(probability q), the chance of a good signal is p′. In that
687
case, the old equity gets all the surplus from the invest-
ment ð1KÞ as well as the value V of assets in place. If
there is no signal, there is no investment and no new
equity issued, so the equity is worth V. Similarly, if the CEO
is retained, the board's payoff is
qp′ðV þ 1KÞ þ ð1qÞð1αR ÞðV þ p′Þ: ð32Þ
Equating the expressions in (31) and (32) gives the same
equilibrium condition as before, Eq. (19). It follows that p′
is unchanged from the analysis in Section 3, as given by
Eq. (20). This allows the ex ante payoffs to the firm under
public and private ownership to be computed.
With private equity, the ex ante payoff on the new
project, including the value of assets in place, is
n π o
V þ E max 0; þpð1πÞK; pK : ð33Þ
2
With public equity, the ex ante payoff is
Z 1
qðV þEðpÞð1KÞÞþ ð1qÞðV þ xK dϕðxÞÞ
p′
Z 1
1
¼ V þ q ð1KÞ þ ð1qÞ pK dϕðpÞ; ð34Þ
2 p′
where p′ is given by Eq. (20). This shows the following
proposition.
Proposition 3. The firm has higher value under private equity
than with stock market financing if:
n π o 1
E max 0; þpð1πÞK; pK 4q ð1KÞ
2 2
þ ð1qÞ Prðp 4 p′ÞðEðpjp 4 p′ÞKÞ; ð35Þ
þ
where p′ ¼ KV=ðVK þ Ep′ Þ.
(a) There is a threshold value of the informativeness of the
market's signal (for given values of the exogenous parameters
of the model other than q), such that if the stock market's
informational production is good ðq 4 q′Þ, then the firm is
worth more with stock market financing than with private
equity. If the market's information is poor ðq oq′Þ, the firm is
worth more with private equity financing.
(b) There is a threshold value of assets in place, V′ (for
given values of the exogenous parameters of the model other
than V), such that if the firm has more assets in place than V′,
then it is worth more with market funding. If the firm's assets
in place are not worth much ðV oV′Þ, then it is more valuable
with private equity financing.
Proof. (a) Setting q ¼ 0; it is clear that private equity is
better because, from the previous analysis,
n π o

E max 0; þpð1πÞK; pK 4Prðp 4p′ÞðEðp
p 4 p′ÞKÞ:
2
ð36Þ
[see the discussion accompanying Eqs. (27) and (28)]. Sett-
ing q ¼1,
n π o 1
E max 0; þpð1πÞK; pK o ð1KÞ; ð37Þ
2 2
so public ownership is better. Because the right-hand side
of Eq. (35) is linear in q and the left-hand side does not
ð31Þ
depend on q, the result follows.
(b) Higher V raises p′, as shown in previous analysis, and
makes public ownership more valuable. □
688 J. Dow / Journal of Financial Economics 110 (2013) 680–695
Proposition 3 shows how the choice between private
and public ownership depends on the value of the existing
assets (V). More assets in place make external financing
cheaper by mitigating the adverse signal sent by firing the
CEO, as discussed in Section 2 (see the comments imme-
diately preceding the statement of Proposition 3). This
favours public ownership relative to private ownership,
which is consistent with evidence in Pagano, Panetta, and
Zingales (1998) that company size increases the likelihood
of a company going public.
5. Discussion of assumptions and extensions
In this section I discuss the robustness of the results to
some of the assumptions and give some extensions. First,
as the market's uncertainty about the board leads to
distorted firing policy, it seems intuitive that a highly
predictable board should increase firm value. This turns
out be to the case. Second, there are several reasons other
than the one modelled in this paper why a board might
care about sending a negative signal about its ability to the
market, and I show that the results of the paper are robust
to some of these different objectives. Third, while the
previous analysis has assumed that assets in place are
fixed and uncorrelated with the payoff on the new project,
I now analyze the case in which they are correlated.
Fourth, I discuss the choice between debt and equity
financing.
5.1. Optimal board choice is conservative
Firms are often criticized for being overly cautious in
selecting board members. Why might a firm ignore the
benefits of diversity and experimentation in selecting
board members, especially when individual board mem-
bers are part of a larger group (the whole board) so that
whenever any individual board member has gaps in
knowledge, the other members can fill those gaps? The
analysis in this paper can provide an answer. If the board
consists of highly experienced members, then the market
will not learn much about the board if it replaces the CEO.
Hence, firing will not send a strong negative signal about
board ability and does not increase the cost of capital
much. Therefore, the firm could prefer to appoint a safe,
experienced board member over a less predictable candi-
date whose expected ability is higher.
To illustrate this, I show that firm value is greater when
the market knows the ability of the board and does not
make any inferences about board ability when the CEO is
replaced. This corresponds to the case in which the CEO is
an IID draw ðπ ¼ 1Þ. Then, the expected chance of success
with a replacement CEO is EðpÞ ¼ 12 and is independent of
the ability of the fired CEO. Firm value is greater in this
case than in the main model ðπ o1Þ for two reasons. A firm
that fires the CEO is still be able to finance the project, and
the firing decision is less distorted.
To distinguish this case from the main model of the
paper, I use an asterisk to denote endogenous variables.
Thus, pn denotes the point below which the CEO is
replaced, αnR denotes dilution, etc. If the CEO is fired, the
market is willing to invest without requiring an excessive
level of dilution, so αnF ¼ K=ðV þ 1=2Þ [from Eq. (17)]. How-
ever, if the CEO is not fired, this signals high ability:
αnR ¼ K=ðV þEpþn Þ. So, although the board would not be
concerned about sending a bad signal of its ability, there
is still a cost because firing means not sending the signal of
a high-quality CEO. This implies that firing is not first-best
but solves
ð1αnF ÞðV þ 12Þ ¼ ð1αnR ÞðV þpn Þ: ð38Þ
n 1
As a result, p is less than the first-best value although it
2,
is less distorted than in the main model where board
ability is uncertain. In Appendix A.4 I show that the firm is
more valuable with board members of known ability
ðπ ¼ 1Þ than with learning about the board. In other words,
optimal board choice is conservative.
This is consistent with the findings in Ahern and
Dittmar (2012), which studies the impact of a Norwegian
law requiring firms to increase diversity by including a
minimum fraction of women on their boards. Ahern and
Dittmar find that the law resulted in a 3.5% fall in share
price, which is attributable to the lower levels of experi-
ence among the incoming (female) board members. Thus,
the paper suggests that lower experience among board
members results in lower firm value. Taking experience as
a proxy for predictability, this can be explained by the
analysis in my paper (an alternative explanation is that
experience directly increases ability through a learning
effect). Experience seems a reasonable proxy for predict-
ability, because if the market has had the opportunity to
observe the performance of the individual over a longer
period of time or in a greater variety of roles, it is more
able to predict her performance.
5.2. Reluctance to replace the CEO is robust to different
board objectives
A corporate board could care about the market's
inferences for several different reasons. In this paper I
assume that the board maximizes the value of existing
equity when raising new financing, as in Myers and Majluf
(1984). This objective function is well accepted in corpo-
rate finance, for example, as an explanation for the
typically negative share price reaction to equity issuance.
It is convenient for studying conflicts of interest between
the board and finance providers, and it allows assets in
place to be considered as well as new investment. Impor-
tantly, the results in my paper show that a first-best
suboptimal firing rule follows from the board maximizing
shareholder value, not from an agency conflict between
board and shareholders. It is, in some sense, less surprising
that entrenchment can also result from the board not
acting in shareholders interests.
However, similar results do obtain with other objective
functions. This is important, because boards could well
consider their own interests as well as shareholders'. They
could be empire builders, or their members could care
about their career prospects and reputations. To see how
these alternative objectives can lead to similar results as
the model of my paper, consider what happens when a
board fires the CEO. Suppose, arguendo, that in the worst
cases the board fires, while in the best cases the board
 J. Dow / Journal of Financial Economics 110 (2013) 680–695
retains the CEO. If so, then in between a point must exist
where it is borderline whether to fire or retain the CEO.
At this point, the board must be indifferent. Consider the
trade-offs faced by the board at this hypothetical border-
line. On the positive side, the replacement CEO would be
more capable. On the negative side, replacement sends a
signal to the market that is unambiguously negative from
several different perspectives. When the CEO is fired, the
board's reputation suffers, the ability to raise financing is
reduced, and the terms of any financing are less favorable.
Because these opposing effects must balance, to the extent
that these negative effects are strong, the positive effects
must be equally strong. This implies that the replacement
CEO is much better, so only very poor CEOs are fired.
To formalize this analysis, I consider a couple of alternative
objective functions: empire building and career concerns.
To model the empire-building motive of the Jensen
(1986) free cash flow theory, I could assume that the board
maximizes the probability of new investment. This seems
overly simplistic because it assumes the board would be
equally happy with new investment that will fail and new
investment that will succeed. A true empire builder should
prefer the latter. So, I assume the board maximizes the
probability of successful new investment.
Regarding career concerns, the board might simply care
about the market's perception of its own ability. Assume
the market forms a Bayesian updated belief about board
quality (conditioned on the decision whether or not to fire
the CEO), and the board seeks to maximize this. Board
members could be motivated by career concerns, although
I do not provide an explicit career concerns model along
the lines of Holmstrom (1982) (Kanodia, Bushman, and
Dickhaut, 1989 show how this could lead management to
stick to previous investment decisions even if they learn
these were suboptimal). Alternatively, board members
could care about this objective for reasons of vanity. It is
intuitive that the board will be better off retaining the
manager [so that the market perceives ability Eðpjp 4p′Þ]
instead of firing [perceived ability Eðpjp o p′Þ], although
the proof (Proposition 7) requires a few additional details.
With these different objective functions, the results of
the paper still stand. Formal statements of results and
proofs are given in Appendix A.2.
5.3. Results are robust if assets in place are correlated
with new project
The model in the main part of the paper assumes for
simplicity that the value of assets in place V could be
random, but, if so, is uncorrelated with the new project.
This assumption makes the model tractable. Intuitively,
however, one would expect that the CEO's ability should
have an effect on cash flows generated by assets in place as
well as on new investments. If one thinks that the CEO's
skill lies in being able to operate assets profitably, then
CEO ability would be expected to have an equal effect on
the value of new assets and of assets in place. If one thinks
that the CEO's skill lies in choosing good projects, or
making the investments in an effective way, then one
would expect that the value of assets in place would be
insensitive to the CEOs skill because the investments have
689
already have been made. (I am assuming there is no
asymmetric information about the quality of assets in
place, in addition to the asymmetric information about
the CEO.) The results can be shown to be qualitatively
robust to generalizing to the case in which the value of
assets in place is correlated with the payoff on new
investment.
For clarity in this subsection, I write V~ for the value of
assets in place, to emphasize that this is a random variable.
As this case is more complex, I restrict attention to π ¼ 12
(see Section 2.1). Let the expected value of assets in place
be VL conditional on the new project failing (with the
existing CEO) and VH conditional on it succeeding (below, I
derive from this the expected value of assets in place if the
CEO is replaced). Although the relation between the
probability distributions of V~ and the project payoff could
take many different functional forms, these two condi-
tional expectations are sufficient to derive the equilibrium.
Two special cases of interest are no correlation ðV L ¼
V H ¼ EV~ Þ and terminal value of assets in place proportional
to value of new project ðV L ¼ 0Þ. The case V L ¼ V H ¼ EV~ is
the one studied previously in the main part of the paper.6
In the case of V L ¼ 0, the CEO has the same influence over
the assets in place as over the new project. Define
V ¼ EV~ ¼ 12ðV L þ V H Þ;
Δ ¼ V H V L : ð39Þ
Let p′ be the threshold for the board's signal below
which the CEO is fired. If the project is funded, then in
equilibrium the market contributes funding K in exchange
for a fraction of equity α whose expected value equals the
funding raised: ðEV þ PrðSuccessÞÞα ¼ K, where both the
value of assets in place and the probability of success are
updated by the market (depending on whether the CEO
has been fired). So,
K
αR ¼ : ð40Þ
V L þ ðΔþ 1ÞEp′þ
If the CEO is fired, no capital is raised, the assets in place
are worth V L þ ð14 þ p=2ÞΔ and, therefore, p′ is given by
 
1 p′
VL þ þ Δ ¼ ð1αR ÞðV L þ ðΔ þ1Þp′Þ
4 2
þ
V L þðΔ þ 1ÞEp′ K
¼ þ ðV L þðΔ þ1Þp′Þ: ð41Þ
V L þ ðΔ þ 1ÞEp′
From Eq. (41) the solution p′ solves
p′ ¼ gðp′Þ; ð42Þ
6
For given VL and VH, the correlation can take any value between
zero and one, so long as VL is different from VH. To see this, suppose that
the realized value of assets in place is V~ ¼ V L þ ε~ or V~ ¼ V H þ ε~ (depending
on the payoff on the new project), where ε~ is independent of the payoff
on the new project. If ε~ is just degenerate with ε~ ¼ 0, we the assets in
place and the new project are perfectly correlated. If ε~ has a very large
variance, the correlation is very small. Because VL and VH are sufficient to
derive the equilibrium, the equilibrium does not depend on the
correlation.
690 J. Dow / Journal of Financial Economics 110 (2013) 680–695
where
1 place cannot be used independently to secure finance for
ΔðV L þ ðΔ þ1ÞExþ Þ þ KV L
gðxÞ  4   : ð43Þ
1 1
ð2 þ ΔÞð1 þΔÞExþ þ 1 þ Δ V L KðΔ þ 1Þ
2 2
p′ has a unique solution on (0,1), because, as shown in
Appendix A.3, g is continuous and decreasing with
0 ogðxÞ o1. A leading special case is when the payoff on
the assets in place is proportional to the new project
payoff. In that case,
V L ¼ 0;
V H ¼ Δ;
V ¼ 12Δ ð44Þ
and g reduces to
2V Exþ
gðxÞ ¼ : ð45Þ
4ð1 þ V ÞExþ 4K
While the solution for p′ depends on the functional form of
the probability distribution, it is bounded above by gð0Þ
and below by gð1Þ, because g is decreasing. It can be shown
that g(x) is increasing in V , gðxÞ⟶0 as V ⟶0, gðxÞ⟶12 as
V ⟶1, and gðxÞ o 12. It follows that, as in the case with
fixed V, the CEO is fired less often than in first best, is
hardly ever fired when assets in place are very small, and
is less entrenched when assets in place are higher. How-
ever, unlike the case with fixed V, the firing threshold does
converge to the first best in the limit with large V. This is
because when the payoff on the assets in place is propor-
tional to the payoff on the new project, their value is
proportional to the CEO's ability. As the assets in place
become more valuable relative to the new project, enhan-
cing their value is of overriding importance compared
with financing the new project. By inspecting Eq. (43), in
the limit with valuable assets in place, the case in which
Δ-1 while VL is constant can be seen to result in gðxÞ-12
and so p′-12. In case V L -1 while Δ is constant, gðxÞ-
ðð1=4ÞΔþ KÞ=ðð1=2ÞΔ þ 1Þ o 12 and so the limiting value of p′
is less than 12.
Proposition 4. Assume the board acts to maximize the value
of existing equity. Assume that the value of assets in place is
proportional to the payoff on the new project. The CEO is fired
if the board's signal of his ability p falls below a threshold p′.
In this event there is no investment. p′ is uniquely deter-
mined. The CEO is fired less often than in first-best: p′ o 12.
The more valuable the assets in place, the more efficient the
firing decision; p′ is strictly increasing in V (where V is the
expected value of the assets in place). When assets in place
are small, the CEO is hardly ever fired; p′-0 as V -0. In the
limit when assets in place are very valuable, the CEO is fired
according to the first-best rule; p′-12 as V -1.
5.4. Debt and equity
The paper has considered equity financing. In this
model, debt and equity are equivalent in the sense that
the terminal value V can take only two possible values.
However, several informal remarks can be made concern-
ing debt financing in this type of model. First, the analysis
requires (as in Myers and Majluf, 1984) that the assets in
the investment. Clearly, if some riskless debt could be
issued secured on V, this should be done first and the
financing need in this paper should be interpreted as the
residual financing required over and above that amount.
Equally, if the firm has some retained cash that is available
to finance the project, it should use do so and V should be
interpreted as the excess. If the firm could finance the
project with risky debt, this would be preferred to equity
because debt is less information sensitive than equity, so
there would be less resulting distortion in CEO firing
policy.
The above comments are standard, as in the pecking
order theory (see, for example, Myers, 1984). However, a
novel prediction can be inferred: Firms that are more
dependent on external equity will have more CEO entrench-
ment. Firms that are dependent on risky debt will have less
CEO entrenchment than those dependent on external
equity, but more than firms that are financed with internal
cash flow or with safe debt.
6. Empirical predictions
The model has several empirical predictions. It obviously
predicts that listed firms will be reluctant to fire their CEOs.
Direct evidence of this is difficult to obtain. However, Taylor
(2010) estimates a structural model and concludes that
firms act, on average, as if firing the CEO costs over 5% of
enterprise value.7 He also finds that this proxy for entrench-
ment falls for larger firms. If larger firms correspond to
those with more assets in place relative to investment
needs, this is compatible with my model.8
The model also predicts that investment should be
related to CEO firing. It predicts that the probability of
CEO turnover should be higher following capital raising.
Boards should try to avoid a situation in which they
want to fire a CEO and then raise capital. They can do this
by waiting until capital is raised before firing the CEO
(this prediction distinguishes the board objective in my
model from the alternative board objectives analyzed in
Appendix A.2). In principle, they would also benefit by
bringing forward capital raising (so that they do not have
to delay replacing the CEO), although it seems unlikely
that boards often have the power to do this. In addition,
the model predicts that firms that fire the CEO are less
likely to invest subsequently.
Board composition should also affect turnover, because
the model is based on board reputation. If the board
members have not changed (or only a small number have
changed) since the CEO was appointed, CEO turnover would
7
He further estimates that the majority of this amount is an implicit
cost or disutility to board members, not a true cost to shareholders. The
total amount estimated is 5.9% of the firm's assets, made up of the
disutility to board members of 4.6% (95% confidence interval: [3.5%,
5.7%]) and a cost to the firm of 1.3% of the firm's assets (95% confidence
interval [0.1%, 2.5%]).
8
He also estimates that the very largest firms have negative
entrenchment, which this model cannot explain. However, this negative
parameter is not statistically significant.
 J. Dow / Journal of Financial Economics 110 (2013) 680–695
be expected to be lower because firing sends a signal about
the board. If more board members have changed, the
signal would be weaker. Hence, reluctance to fire would
be reduced. Such evidence, however, would be unable to
distinguish between the main hypothesis advanced in this
paper — that the board's concern for reputation is based
on shareholder value maximization through the ability to
raise financing — with the alternative hypothesis (see
Section 5.2) that board members might care mostly about
their own career concerns.
What is the predicted impact of CEO firing on share
price? While the model describes only the board's private
signals on CEO ability, in reality situations arise in which the
market learns about CEO ability. In other words, there is a
public signal on CEO ability. Although the model does not
incorporate public signals, it allows a discussion of the effect
they would have on the model's predictions. A public signal
could happen in two different ways. The news about CEO
ability could simultaneously become known to both the
board and the market (public signal without a previous
private signal). Alternatively, the news about the CEO could
become known to the board first and later to the market
(private signal followed by a public signal). In the former
case, firing would be expected to have no impact on share
price. The bad news would be incorporated in the share price
as soon as the signal arrives. Then, when the CEO is fired in
response to this news, no further price reaction would occur.
This interpretation assumes a passage of time exists between
the market realizing the CEO should be replaced and the
actual announcement by the company, as seems reasonable
(in extreme cases, the news about the CEO could be so bad
that he would have to be dismissed immediately and there
would be a negative effect. However, this is an extreme, and
likely infrequent case). If the public signal arrives after the
board has received a private signal, the model predicts that
sometimes the board will have decided not to fire, so firing
occurs after the public signal and, therefore, without a price
reaction. In other cases, the board fires on receipt of the
private signal and there is a negative reaction. So firing in
response to private signals becomes less frequent, while
firing in response to public signals becomes more frequent
(when the comparisons are relative to an otherwise identical
model in which the board's decision making puts no weight
on the cost of financing).9 Because firing in response to a
private signal should have a negative effect on share price,
and firing in response to a public signal should have no
effect, overall the effects studied in the model lead to the
conclusion that firing should have a negative effect on share
price, but the effect should be smaller than it would
otherwise be. Another empirical implication (especially for
large and prominent companies) is that, if the firing is not
preceded by any press discussion about the CEO's ability, it
should have a large negative impact on share price. The
predicted effect is obviously negative. However, the effect
9
Firing in response to private signals becomes less frequent because
some of the firings that would otherwise take place in response to the
private signal do not. Firing in response to a public signal becomes more
frequent because some of the firings that would have happened earlier in
response to a private signal to the board are postponed until the arrival of
the public signal.
691
should be larger than in an otherwise identical model in
which the board's decision making puts no weight on the
cost of financing.
A number of papers have reported the announcement
effects of CEO turnover. Furtado and Karan (1990) survey the
earlier papers, which mostly report announcement effects of
71% or smaller; for example, Warner, Watts, and Wruck
(1988) report a statistically insignificant effect of 0.31%.10
However, more recent studies isolate cases of forced turnover
by following the Parrino (1997) definition of firing11 and are
based on larger sample sizes (Huson, Parrino, and Starks,
2001; Huson, Malatesta, and Parrino, 2004; Jenter and
Kanaan, 2006). Huson, Parrino, and Starks (2001) find a
positive effect on share price of 2% for forced turnover.12
Huson, Malatesta, and Parrino (2004) find that firing has a
significantly positive effect of about 2% in cases when the new
CEO is an outsider and an insignificantly negative effect where
the new CEO is an insider.13 However, Jenter and Kanaan
(2006) show negative announcement effects around forced
CEO turnover of about  1.7%.14 To summarize, while
researchers have found effects that are slightly negative or
insignificant, consistent with the predictions above, two of the
more recent studies point to a positive announcement effect.
To explain a positive announcement effect requires a
different explanation. A possible explanation is that the
market had already learned that the CEO should be replaced,
but the board has only just realized it. Alternatively, both the
market and the board could have realized that the CEO should
be replaced, but the market believed the CEO had the ability
to block or delay firing and, therefore, did not know the board
would be successful in firing the CEO at this time. In principle,
these explanations could be combined with this paper's core
assumption that firing sends a negative signal about the board
and, hence, boards could be reluctant to fire. A further
explanation, suggested by Hermalin and Weisbach (1998), is
that the market had not previously learned that the CEO
10
See Exhibit 4 of Furtado and Karan (1990) for a summary of results
from surveyed papers. Warner, Watts, and Wruck report an effect of
0.31% with a z-statistic of 1.36 (see p. 482).
11
Parrino (1997) defines firing as cases in which press reports
indicate that the CEO was fired, forced, left following a policy disagree-
ment, or some other equivalent, or when the CEO is under 60 and the first
article reporting the announcement does not state the reason for the
departure as involving death, poor health or acceptance of another job.
12
The average abnormal return of 127 forced turnover events over
the period 1971–1994 is 2.02% with a P-value of 0.000. The effect varies
over different subperiods. See Huson, Parrino, and Starks (2001, Table 8,
p. 2295).
13
The average abnormal return for 111 cases of forced turnover in
which an outsider is appointed, over the period 1971–1995, is 2.126%
with a t-statistic of 1.86. The average for 94 cases in which an insider is
appointed is  0.832 with a t-statistic of 1.20. See Huson, Malatesta, and
Parrino (2004, p. 258).
14
See Jenter and Kanaan, 2006, Table 14, p. 49). The data are
partitioned into four subsamples depending on industry under-
performance or outperformance and on the idiosyncratic stock return
under-performance or outperformance. The weighted average of the
return across the four subsamples is  1.70%. ð1:70 ¼ 366 36
 3:46þ 366
20

3:62 þ 198
366  1:18 þ 366  1:7Þ. Other versions of the Jenter-Kanaan paper
112
do not include the table showing announcement effects. The reference is
to the National Bureau of Economic Research working paper (number
12068).
692 J. Dow / Journal of Financial Economics 110 (2013) 680–695
should be replaced, but firing simultaneously sent a positive
signal about the board and a negative signal about the CEO.15
The model does predict that unanticipated firing should
have a negative effect, although the empirical literature on
firing has not investigated this.
Some literature has studied the stock price response
when the CEO leaves for an exogenous, unanticipated reason
— specifically, when the CEO dies suddenly. Several papers
have found a positive stock price response to this event
(Johnson, Magee, Nagarajan, and Newman, 1985; Hayes and
Schaefer, 1999) although the more recent study of senior
executives by Nguyen and Nielsen (2010) shows a negative
(but insignificant) reaction.16
In the model, the stock price response depends on the
balance between two opposite effects. Assume the CEO
dies after an interval of time since appointment. So, it is
reasonable to suppose the board has received some private
information on ability.17 If the board received a signal but
did not fire the CEO, this means the CEO was above
average (i.e., the signal was above p′). So, one effect is
that, to the extent the CEO was above average within the
distribution of CEOs accessed by the board, it is bad news
that the CEO has died. To the extent the CEO was above
average, this signals the board could be accessing a good
distribution of CEOs, which is good news. Thus, in this
model, an empirical finding of a positive announcement
effect of CEO death is evidence of significant uncertainty
about board ability.
The analysis of private versus public equity ownership
(Section 4) implies that CEO turnover is higher in private
firms, as public firm boards are reluctant to fire in some
cases in which firing is first-best. This comparison applies
to privately owned firms whose owners have reliable
access to funding. Empirical testing of this prediction also
needs to recognize that firms that go public could differ
from firms that are privately owned. For example, a greater
fraction of privately owned firms could have a founder
who is simultaneously owner or blockholder and CEO and
who is unlikely to fire himself. Alternatively, the kinds of
tasks required of the CEO could differ because the com-
plexity, growth potential, needs for change, or other
characteristics could differ between public and privately
owned firms. Cornelli and Karakas (2012) control for this
by studying public firms that are taken private by private
15
I argue that firing sends a negative signal about board ability, but
an alternative argument is put forward by Hermalin and Weisbach
(1998). If some boards are more independent, in the sense that they
have a lower cost of monitoring the CEO, and if the market does not know
how independent they are, firing could be a good signal.
16
Johnson, Magee, Nagarajan, and Newman (1985) study 53 CEO
observations from 1971 to 1982 with an average announcement effect of
0.4%. Hayes and Schaefer (1999) report a 2.84% positive reaction to 29
sudden CEO deaths over the period 1979–1994 (standard error 0.82,
implying a t-ratio of 3.46). The Nguyen and Nielsen (2010) study of 149
executives shows a (statistically insignificant) 1.22% negative reaction
over the period 1991–2008; however, this sample includes 81 CEOs and
68 other senior managers.
17
If the CEO dies soon after being appointed, it is unlikely the board
has received a signal. When a replacement CEO is appointed, it is
reasonable to assume the board still has the option to fire and replace
this CEO. Then, effectively, the situation is just back at the start of the
model; that is, the death should have no announcement effect.
equity owners, and comparing them with a matched
sample of firms that remain publicly listed.18 They find
that CEO turnover is higher in the private equity group.19
Finally, the model in this paper predicts that firms that
are more dependent on external financing (such as growth
firms) will be more conservative in their choice of board
members. Conservatism could be proxied by the number of
board members' other board memberships, or by whether
board members have previously served as CEOs (as in
Ahern and Dittmar, 2012).
7. Conclusion
This paper argues that corporate boards are reluctant to
fire the CEO because of the future impact on the firm's
ability to obtain finance and the cost of that finance. This
entrenchment result differs from existing literature
because entrenchment is not a consequence of the CEO's
own power or from collusion between board and CEO.
Entrenchment is mitigated, but not eliminated, when the
firm has more assets in place relative to investment
opportunities. The model predicts that firms that fire the
CEO are less likely to raise finance shortly afterwards and
that this effect should be larger for firms with less valuable
assets in place.
The paper also compares private equity ownership with
publicly listed firms. Private ownership eliminates the
costs of CEO entrenchment, but a stock market listing
adds to firm value because the share price can guide
investment decisions. Other things equal, established firms
whose existing assets are valuable compared with their
investment opportunities choose publicly listed status, while
more rapidly growing firms choose private ownership.
One implication of the model is that publicly listed
firms will be more valuable if board members are chosen
conservatively. If board members are well-known and
predictable, it could be better for firm value than if they
are talented but inexperienced. The model predicts that
firms that are more dependent on outside financing
should prefer experienced board members.
A final remark concerns regulation or public policy. The
model shows that, if boards maximize shareholder value,
CEOs will be entrenched in the sense of not being fired
even when the board learns they have low ability. How-
ever, it does not follow that government regulators or
activist investors should be content with the status quo
and should refrain from any intervention. In the model,
it would be ex ante optimal if the board had a mechanism
to commit to a stricter firing rule. Potentially, corporate
18
The private owners in the Cornelli and Karakas (2012) sample are
mostly well-funded private equity groups whose continued ability to
raise funding depends on their overall track record, not the success or
failure of an individual firm in their portfolio. Hence, the analysis in
Section 4 should apply.
19
This comparison includes all CEO turnover, including turnover that
occurs soon after the change of ownership. Cornelli and Karakas (2012,
p. 10) focus primarily on board intervention and turnover for the CEO
chosen by the incoming private equity owner, so their primary measure
of turnover is exclusive of CEO replacement that occurs shortly following
acquisition by the private equity owner.
 J. Dow / Journal of Financial Economics 110 (2013) 680–695 693

governance rules or shareholder-influenced changes to the 1

corporate charter could help achieve this.

0.8
Appendix A

A.1. Details of derivations 0.6

p'
Details for derivation of Eq. (20):
0.4
K
αR ¼ þ; ð46Þ
V þEp′
0.2
so
þ
V þ Ep′ K
1αR ¼ þ : ð47Þ 0
V þ Ep′ 0 1 2 3 4 5
Assets in place V
Then,
þ Fig. A1. Firing threshold p′ as a function of assets in place V. The dashed
V þ Ep′ K line shows the limV-1 p′ ¼ K. The first best value is 1/2. The graph is
V¼ þ ðV þ p′Þ ð48Þ
V þ Ep′ drawn for K¼ 3/8, for π ¼ 1=2, and for p uniform. The formula for p′ is
shown in Eq. (55).

V ) 0 ¼ KV þp′V þ p′Epþ p′K; ð49Þ

Proposition 6. If the board's objective is to maximize the
so probability of successful new investment, then the unique
KV equilibrium is for the board never to fire the manager and the
p′ ¼ : ð50Þ market always to invest.
VK þ Epþ

Details for derivation of Eq. (26): Eq. (25) is Proposition 7. If the objective is to maximize the market's
1 þp′ perception of the board's quality as proxied by its posterior
0 ¼ KV þ p′ðVKÞ þ p′ ð51Þ expectation of p, the unique equilibrium is for the board
2
never to fire the CEO and the market always to invest.
 
1 1
0 ¼ p′2 þ p′ VK þ KV; ð52Þ

2 2 Proof of Proposition 5. If the condition Eðp
p op′Þ Z 2K12 is
satisfied, the market will invest whether the CEO is fired or
so, using the equation for the solution of a quadratic
retained and the board will be indifferent between firing
equation,
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi and retaining, so this is an equilibrium. □
   
1 1 2 1
p′ ¼  VK þ 7 VK þ þ4  KV  ð53Þ
2 2 2 Proof of Proposition 6. Suppose that in equilibrium the CEO
is fired whenever p op′, where p′4 0. Suppose further
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
    that in response to the CEO being fired, the market does
1 1 2
p′ ¼  VK þ 7 V 2 þ K þV: ð54Þ not invest. This cannot be an equilibrium because the
2 2
board will be better off keeping the manager (leading to
Note from Eq. (53) that the absolute value of the term investment and a positive probability p of positive equity
with the square root sign always exceeds the first term. value) instead of firing (leading to no investment and,
Therefore, the correct solution for p′ is hence, zero chance of positive equity value). Now suppose
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi instead that in response to the CEO being fired the market
  2
p′ ¼  VK þ 12 þ V 2 þ K12 þV: ð55Þ does invest. This implies


Fig. A1 plots the solution as a function of V. Eðp
p o p′Þ Z2K12: ð56Þ

A.2. Generalization with respect to alternative
board objectives
Assume the firm has no other assets apart from the
project (V¼ 0), because the following objective functions
do not incorporate a trade-off between sending a good
signal to the market and protecting assets in place.
Proposition 5. If the board's objective is to maximize the
probability of investment, then there are multiple equilibria.
It is an equilibrium for the
CEO to be fired for p o p′, where p′
is any value satisfying Eðp
p op′Þ Z 2K12.
It must be that p′ ¼ 12, because the investment will take
place regardless of whether the manager is fired or
retained, and the board will prefer to fire in case p o 12
and retain in case p 4 12 as this increases the chance of
positive equity value. There

is, therefore, a contradiction of
the assumption that Eðp
p o 12Þ o2K12, so, in equilibrium,
investment cannot happen when the CEO is fired. Finally, if
the CEO is never fired, but firing would lead to no
investment, this is an equilibrium because the board
would prefer not to fire (leading to investment and a
positive chance of success) than to fire (leading to no
investment). □
694 J. Dow / Journal of Financial Economics 110 (2013) 680–695

  2 þ
Proof of Proposition 7. Suppose the CEO is fired whenever 1 1 ∂Ex
p op′, for some p′ A ð0; 1Þ. Then, following a firing, the  ð2 þ ΔÞð1 þΔÞExþ þ 1 þ Δ V L KðΔ þ 1Þ :
2 2 ∂x
board's payoff is Eðpjp o p′Þ. If the CEO is retained the ð60Þ
payoff is Eðpjp 4p′Þ. So, the board will always choose to
retain the CEO. What about if p′ ¼ 0 or 1? In the former This is negative because the numerator (the term on the
case, the CEO is never fired; in the latter, the CEO is always first two lines enclosed by { }) is
fired. Thus, Bayes' rule does not apply to the out-of- ½14 ΔðΔ þ 1Þ12 ð2 þ ΔÞð1 þ ΔÞExþ þ 14 ΔðΔ þ 1Þð1 þ 12ΔÞV L
equilibrium events (retaining in the former case; firing in
14ΔðΔ þ 1ÞKðΔ þ1Þ
the latter). It is natural to assume that if p′ ¼ 0 (CEO never
fired) the market will not interpret a firing as a signal of a ½14 ΔðV L þðΔ þ1ÞExþ Þ þ KV L 12ð2 þ ΔÞð1 þ ΔÞ
 
better than average CEO, so this is an equilibrium. It is also ¼ 12 KðΔ þ 1Þ 12ΔðΔ þ 1ÞV L ð2 þΔÞ o 0: ð61Þ
natural to assume that if p′ ¼ 1 (the CEO is always fired)
the market will interpret not firing the CEO as a good
signal, so this is not an equilibrium. □ A.4. Conservatism in board choice

It is immediate from the argument in the proof that Consider the equilibrium condition, Eq. (38):
Proposition 7 could be generalized: If the objective is to  
1
maximize the market's perception of the board's quality as ð1αnF Þ V þ ¼ ð1αnR ÞðV þ pn Þ
2
proxied by any function of the posterior distribution that !
strictly increases when the market's posterior distribution of 1 K
3 V þ K ¼ 1 ðV þ pn Þ: ð62Þ
p changes by shifting up in the sense of first-order stochastic 2 V þEpþn
dominance, the unique equilibrium is for the board never to
This equation determining pn can be contrasted with
fire the CEO and the market always to invest.
the corresponding equation for p′ in the case with indif-
ference [Eq. (19)]:
A.3. Generalization to the case in which assets in place are !
K
correlated with the new project payoff V ¼ 1 þ ðV þ p′Þ: ð63Þ
V þ Ep′
I need to show g is continuous and decreasing with Consider the function hðxÞ  ð1K=ðV þExþ ÞÞðV þ xÞ.
0 ogðxÞ o1. To show g is continuous and gðxÞ 4 0; note Because p′ is determined by hðxÞ ¼ V, while pn is deter-
that the denominator in Eq. (43) is strictly positive because mined by hðxÞ ¼ V þ 12K 4 V, and h is increasing, it follows
  that pn 4 p′. To see that h is increasing, note that
1
1þ Δ   !
1 1 1 1 1 2 ∂h ∂Exþ
K o r ð2 þ ΔÞ r ð2 þ ΔÞExþ o ð2 þ ΔÞExþ þ V L: ¼ 1
K
þ
K
ðV þ xÞ 40: ð64Þ
2 2 2 2 2 ð1 þ ΔÞ V þ Exþ
∂x ðV þ Exþ Þ2 ∂x
ð57Þ
To compare firm value when there is no inference about
Next gð0Þ o 1, as the board ðπ ¼ 1Þ with the case in which there is learning,
 
1 1 note that expected value created by the firm is
Δ V L þ ðΔ þ 1Þ þ KV L Z 1
4 2
gð0Þ ¼  
1 1 1 ðpKÞ dp ð65Þ
ð2 þΔÞð1 þ ΔÞ þ 1 þ Δ V L KðΔ þ1Þ p′
2 2 2
  in the case with learning about the board and
1 1
Δ þ K V L þ ΔðΔ þ1Þ Z pn   Z 1
4 8 1
¼  o1; ð58Þ K dp þ ðpKÞ dp ð66Þ
1 1 2 pn
1 þ Δ V L þ ð2 þ ΔÞð1 þΔÞKðΔ þ 1Þ 0
2 4
without learning.
where the inequality follows as 18Δ2 þ 18Δ o 14ð2 þ ΔÞð1 þΔÞK Because in equilibrium, the market provides competi-
ðΔ þ1Þ because tive financing, all this value goes to the firm's owners.
As p′ o K, increasing the threshold for firing is beneficial.
Δ2 þ Δ o 2ð2 þ 3Δ þ Δ2 Þ8KΔ8K; There are two cases to consider.
as 0 o 4 þ5Δ þ Δ2 8KΔ8K Case (i): Suppose pn r K, then
Z 1 Z 1 Z 1 Z pn  
( 0 o4 þ5Δ þ Δ2 4Δ4 o 4 þ 5Δþ Δ2 8KΔ8K ðpKÞ dp o ðpKÞ dp o ðpKÞ dp þ
1
K dp:
p′ pn pn 0 2
( 0 oΔ þ Δ2 : ð59Þ
ð67Þ
Next, the slope is given by Case (ii): Suppose p 4K, then n


   Z Z Z   Z 1
∂g 1 1 1 1 1 pn
1
¼ ð2 þ ΔÞð1 þ ΔÞExþ þ 1 þ Δ V L KðΔþ 1Þ ΔðΔ þ1Þ ðpKÞ dp o ðpKÞ dp o K dp þ ðpKÞ dp
∂x 2 2 4 p′ K K 2 pn


Z pn   Z 1
1 1 1
o K dp þ ðpKÞ dp: ð68Þ
 ΔðV L þ ðΔ þ1ÞExþ Þ þ KV L ð2 þ ΔÞð1 þ ΔÞ 0 2 pn
4 2
 J. Dow / Journal of Financial Economics 110 (2013) 680–695
The uniform distribution can be used as an example to
illustrate the result. With the uniform distribution, pn is
determined by
0 1
1 B K C
V þ K ¼ B
@1
CðV þ pn Þ:
2 1 þpn A
Vþ
2
As p′-0, the right-hand side tends to ð1K=ðV þ 1=2ÞÞ
V ¼ V=ðV þ 1=2ÞðV þ 12KÞ. With V¼0, this is 0. With V
large, this is large. As p′-1, the right-hand side tends to
ð1K=ðV þ 1ÞÞðV þ1Þ ¼ VK þ 1. With V¼0, this is 1K.
With V large, this is large.
From Eq. (69), x ¼ pn solves V þ 12K ¼ ð1K=ðV þ
ð1 þ xÞ=2ÞðV þ xÞ, i.e.,
1 V þx
V þ K ¼ ð2V2K þx þ1Þ;
2 2V þ x þ1
so the solution is given by jðxÞ ¼ 0, where
jðxÞ  VK12 x þKx2Vxx2 þ 12:
j is a concave quadratic with
jð0Þ ¼ VK þ 12 4 0;
jð12 Þ ¼ VK14 þ 12 KV14 þ 12 ¼ 12K o0;
and
j′ð0Þ ¼ 12 þ K2V o 0;
so j has one and only one positive root, which lies
between 0 and 12. By inspection,
jðKÞ ¼ VK12 K þ K 2 2VKK 2 þ 12 ¼ V32 K2VK þ 12
can take positive or negative values depending on K and
V, so p* could be either more or less than K.
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