Capital budgeting and compensation with asymmetric information and moral hazard

Abstract: We consider optimal capital allocation and managerial compensation mechanisms for decentralize firms when division managers have an incentie to misrepresent project quality and to minimize privately costly but value-enhancing effort. We show that in the optimal mechanism firms always underinvest in capital relative to a naive application of the net present value. We make a number of novel cross-sectional predictions about the severity of the underinvestment 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. Managers may thus receive greater performance-based pay because they manager higher quality projects, not that greater performance-based pay causes firm value to increase.

Keywords: Capital budgering; Compensation; Asymmetric information; Moral hazard; Mechanism design; Investment policy

Capital budgeting and compensation with asymmetric information and moral hazard.pdf