Two essays on agency problems and contracting

In Chapter 1, by using a simple model with moral hazard and managerial entrenchment, I derive the optimal debt design that includes investment covenants. The model features the rent-seeking manager, whose investment appetite can be curbed by the shareholders through selective application of the investment restricting rule. However, I show that shareholders' actions are too restrictive to motivate the managerial effort. Delegating the investment monitoring to the debt holders who can achieve an optimal combination of managerial effort and investment rules under proper capital structure is therefore optimal. Under the model assumptions, the debt contract with the investment covenant dominates all other contracts. In Chapter 2, I turn from pure contracting problem to the capital investment under agency problems and contracting. I extend a model of q theory of investment with agency costs (DeMarzo et al. 2011) into a dynamic setting, adopting two types of agency costs: investment diversion and output misreporting. I propose an incentive compatible contract to the agent, and derive the optimal investment policy. The model predicts the cross-sectional difference of stock return response to investment (investment anomalies) and I test this implication in an investment-based asset pricing framework. The empirical results are consistent with the model's prediction. I find that the q theory of investment with agency costs links idiosyncratic risk, earning surprise and investment anomalies with cross-sectional returns in a rational framework