This dissertation is comprised of three articles. The first article examines the importance of capital market imperfections by investigating the dependence of a firm's investment on its internal resources. I exploit the tax loss carryforward feature of the tax code to establish that corporate investments are causally affected by the internal resources available to the firm. The degree of dependence, in turn, is affected by the costliness of debt market financing. Distributions to shareholders are not affected by incremental internal resources, and borrowing actually increases with incremental internal resources. Firms retain a significant portion of incremental cash flow. Taken together, these findings confirm the existence of capital constraints imposed by costs of access to external finance.

The second article focuses on the cost of inflating reports of financial performance and its consequences for the efficiency of investment in the economy. It is well-established that adverse selection in the capital market can cause firms with positive NPV projects to underinvest. The financial accounting system can alleviate this problem by making it more costly for firms to exaggerate their performance. However, I argue that making performance inflation more costly can also lead to overinvestment by leading to equilibrium overpricing of firms with negative NPV projects. Increasing the cost of performance inflation beyond a certain point results in less efficient investment even though it reduces equilibrium misreporting.

The third article presents an explanation for the commonly-observed link between managerial pay and stock price over the short term that focuses on managerial risk-taking incentives. It is well accepted that aligning managerial incentives with those of stock holders enhances shareholder value. In theory models, such alignment is usually modeled as giving managers a stake in the realized cash flows of the firm's projects. However, such a stake, which entails a manager holding on to her equity position until all cash flow uncertainty is resolved, can lead a risk averse manager to turn down risky positive NPV projects. This chapter argues that equity-linked incentives can mitigate the manager's bias against assuming risk, provided the manager is allowed the flexibility of trading out her equity position early. Thus, allowing managers to hedge away partially the risks associated with their firm's stock price may actually be in the shareholders' best interests.