Capital budgeting and compensation with asymmetric information and moral hazard

We consider optimal capital allocation and managerial compensation mechanisms for decentralized firms when division managers have an incentive to misrepresent project quality and to minimize privately costly but value-enhancing effort. We show that in the optimal mechanism firms always under invest in capital relative to a naive application of the net present value (NPV) rule. We make a number of novel cross-sectional predictions about the severity of the under investment problem and the composition of managerial compensation contracts. We also find that firms will optimally give greater performance-based pay (at the expense of fixed wages) to managers of higher quality projects to mitigate the incentive for managers to overstate project quality. Thus, managers may receive greater performance-based pay because they manage higher-quality projects, not that greater performance-based pay causes firm value to increase.

[1]  Artur Raviv,et al.  The Capital Budgeting Process: Incentives and Information , 1996 .

[2]  Artur Raviv,et al.  Capital Budgeting and Delegation , 1997 .

[3]  D. Scharfstein,et al.  Internal Versus External Capital Markets , 1994 .

[4]  William P. Rogerson,et al.  THE FIRST-ORDER APPROACH TO PRINCIPAL-AGENT PROBLEMS , 1985 .

[5]  John Joseph McCall,et al.  The Economics of Information and Uncertainty , 1982 .

[6]  J. Laffont,et al.  Using Cost Observation to Regulate Firms , 1986, Journal of Political Economy.

[7]  Paul R. Milgrom,et al.  AGGREGATION AND LINEARITY IN THE PROVISION OF INTERTEMPORAL INCENTIVES , 1987 .

[8]  Ronen Israel,et al.  Current version: , 2008 .

[9]  M. C. Jensen,et al.  Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers , 1999 .

[10]  R. Preston McAfee,et al.  Competition for Agency Contracts , 1987 .

[11]  M. Harris,et al.  Capital budgeting and delegation1We thank Bhagwan Chowdhry, Yaniv Grinstein, an anonymous referee, and seminar participants at Columbia, Duke, Hong Kong University of Science and Technology, Indiana, Tel Aviv, Vanderbilt, and the European Finance Association Meetings (Vienna, 1997).1 , 1998 .

[12]  Charles H. Kriebel,et al.  Asymmetric Information, Incentives and Intrafirm Resource Allocation , 1982 .

[13]  Bengt Holmstrom,et al.  Managerial Incentives and Capital Management , 1986 .

[14]  J. Laffont,et al.  A Theory of Incentives in Procurement and Regulation , 1993 .

[15]  Guochang Zhang.  Moral Hazard in Corporate Investment and the Disciplinary Role of Voluntary Capital Rationing , 1997 .

[16]  J. Stein,et al.  Internal Capital Markets and the Competition for Corporate Resources , 1995 .

[17]  Gary D. Eppen,et al.  Capital Rationing and Organizational Slack in Capital Budgeting , 1985 .