Controlling Investment Decisions: Depreciation- and Capital Charges

This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and to base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.

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