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Capital Budgeting in Multidivision Firms: Information, Agency, and Incentives

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  • Antonio E. Bernardo

Abstract

We examine optimal capital allocation and managerial compensation in a firm with two investment projects (divisions) each run by a risk-neutral manager who can provide (i) (unverifiable) information about project quality and (ii) (unverifiable) access to value-enhancing, but privately costly resources. The optimal managerial compensation contract offers greater performance pay and a lower salary when managers report that their project is higher quality. The firm generally underinvests in capital and managers underutilize resources (relative to first-best). We also derive cross-sectional predictions about the sensitivity of investment in one division to the quality of investment opportunities in the other division, and the relative importance of division-level and firm-level performance-based pay in managerial compensation contracts. Copyright 2004, Oxford University Press.

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  • Antonio E. Bernardo, 2004. "Capital Budgeting in Multidivision Firms: Information, Agency, and Incentives," The Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 739-767.
    • Handle: RePEc:oup:rfinst:v:17:y:2004:i:3:p:739-767
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