Marginal Cost of Capacity for the Case of Overlapping Capacity Investments

We examine a setting where the owner of a company delegates the authority to make overlapping capacity investments to an impatient manager. If the manager’s internal interest rate exceeds the owner’s cost of capital, a discrepancy arises between the owner’s and the manager’s perceived marginal cost of capacity, which is based on future cash flows associated with new capacity investments. This, however, leads the manager to capacity underinvestment. We argue that by using the performance measure residual income, in conjunction with particular depreciation rules, such as the relative practical capacity (RPC) depreciation rule, it is possible to avoid creating an underinvestment incentive for the manager. We begin by examining the effect direction of a deviation from the RPC depreciation rule on the manager’s perceived marginal cost of capacity, which is based on future cost charges associated with new capacity investments. We then analyze the magnitude of the distortion of the manager’s perceived marginal cost of capacity if the most convenient straight-line depreciation rule and the annuity depreciation rule are used.