Capital Budgeting and Compensation with Asymmetric Information and Moral Hazard
Among the most important objectives of financial economics is advising firms on how to make investment decisions. Finance theory prescribes the net present value (NPV) rule which states that a firm should take an investment project when the present value of its expected future cash flows, discounted appropriately for the project's riskiness, exceeds the cost of investment. However, the NPV rule, naively applied, does not account for the information and incentive problems that can emerge in a decentralized firm. In particular, a firm's headquarters may have to rely on information about future cash flows provided by better-informed division managers. Moreover, a project's future cash flows may depend on unobservable managerial input (e.g. effort). If headquarters must provide incentives for the manager to report project quality truthfully and/or to give appropriate effort, the firm may find it optimal to allocate capital differently than prescribed by the NPV rule.
The optimal amount of capital to allocate to the project depends on its quality (i.e. expected future cash flows) which is unknown to the firm's headquarters. However, headquarters can hire a risk-neutral project manager who does know its quality. The division manager is assumed to enjoy private benefits from controlling more capital, reflecting a preference for "empire building" or greater perquisite consumption and reputation that comes from running a larger business. After joining the firm, the manager reports a (unverifiable) project quality to headquarters which then allocates capital according to the report. Once capital is allocated to the project, the manager can also provide input (e.g. effort) which enhances the project cash flows but is costly to the manager and unverifiable by headquarters.
Absent an explicit incentive scheme, the division manager will always wish to report the maximum project quality (to...