Capital budgeting in multi-division firms: Information, agency, and incentives

Topics: Investment, Management, Resource allocation Pages: 44 (12099 words) Published: May 25, 2014
1

gnoK gnoH ,yaB retaW raelC ,TSUKH ,ecnaniF fo tnemtrapeD §
ASU ,7741-59009 AC ,selegnA soL ,ALCU ,scimonocE fo tnemtrapeD ‡ ude.alcu.nosredna@dranreba :liam-e .8912-528 )013(
:hp .ASU ,1841-59009 AC ,selegnA soL ,ALCU ta loohcS nosrednA ehT :rohtua gnidnopserroC † .sruo era srorre llA .pihswolleF nuL ieW eht morf troppus laicnanfi egdelwonkca ot ekil osla dluow ouL .snoitseggus dna stnemmoc lufpleh rof elaY dna retsehcoR ,nretsewhtroN ,TIM ,TSUKH ,hceT aigroeG ,gnoK gnoH fo ytisrevinU ytiC ,ogacihC ta stnapicitrap ranimes dna ,)namhsiF ekiM( rotide eht ,seerefer suomynona owt ,sotnaS onaT ,aicraG ogeiD ,leinaD neevaN knaht eW ∗

June 20, 2003
§

Jiang Luo



Hongbin Cai



Antonio E. Bernardo

Information, agency, and incentives∗
Capital budgeting in multi-division firms:

2

.stcartnoc noitasnepmoc laireganam
ni yap desab-ecnamrofrep level-mrfi dna level-noisivid fo ecnatropmi evitaler eht dna ,noisivid rehto eht ni seitinutroppo tnemtsevni fo ytilauq eht ot noisivid eno ni tnemtsevni fo ytivitisnes eht tuoba snoitciderp lanoitces-ssorc evired osla eW .)tseb-tsrfi ot evitaler( secruoser eziliturednu sreganam dna latipac ni stsevnired -nu yllareneg mrfi ehT .ytilauq rehgih si tcej orp rieht taht troper sreganam nehw yralas rewol a dna yap ecnamrofrep retaerg sreffo tcartnoc noitasnepmoc lairega -nam lamitpo ehT .secruoser ,yltsoc yletavirp tub ,gnicnahne-eulav ot ssecca )elba -fiirevnu( )ii( dna ytilauq tcej orp tuoba noitamrofni )elbafiirevnu( )i( edivorp nac ohw reganam lartuen-ksir a yb nur hcae )snoisivid( stcej orp tnemtsevni owt htiw mrfi a ni noitasnepmoc laireganam dna noitacolla latipac lamitpo enimaxe eW

tcartsbA

1

Introduction

The long-term health of a firm is determined by the quality of its investments. In a typical firm, capital is allocated to investment projects based on reports by division managers who have access to private information about project quality. The eventual success of any project may also require the input and cooperation of other managers who control access to valuable resources within the firm. The firm, however, may not 1

be able to either independently verify the managers’ reports or monitor the actions of managers to ensure that they are deploying and sharing their resources appropriately. Thus, to secure its long-term health, the firm must provide incentives to encourage truthful information and the appropriate utilization of managerial resources. In this paper, we present a simple model to illustrate these information and incentive problems in a multi-division firm. Specifically, we consider a firm with unlimited access to capital and two investment projects. The optimal amount of capital to allocate to each project depends on its quality which is unknown to the firm’s headquarters. For each project, however, the firm can hire a risk-neutral manager with private information which is useful for assessing the quality of both projects. Once hired, each manager reports her information (not necessarily truthfully) to headquarters which then allocates capital according to the reports. The veracity of the reports is assumed to be non-verifiable and non-contractible. Once capital is allocated, project cash flows can be enhanced by either or both managers by deploying resources under their control. The use of these resources is assumed to be privately costly, non-verifiable, and non-contractible.

.stekram latipac lanretxe dna lanretni fo stfieneb
dna stsoc eht dnatsrednu pleh ot sretrauqdaeh fo elor evitcudorp eht ledom ylticilpxe )7991( nietS dna )4991( nietS dna ,nietsfrahcS ,rentreG .ssecorp noitcudorp eht ot elbasnepsidni si sretrauqdaeh s’mrfi eht os ,ton od sreganam noisivid tub latipac ot ssecca sah mrfi eht emussa osla eW .mrfi eht fo epocs eht nevig sa ekat ew ,rehtar ;repap siht ni mrfi eht fo seiradnuob eht ezylana ylticilpxe ton od ew ,revewoH .mrfi emas eht nihtiw tsixe snoisivid eht nosaer eht eb llew yrev yam snoisivid rehto ni elbaliava secruoser eht no...

References: [1] Antle, R., and G. Eppen, 1985, “Capital Rationing and Organizational Slack in
Capital Budgeting,” Management Science, 31, 163-174.
[2] Berkovitch, E., and R. Israel, 2003, “Why the NPV Criterion does not Maximize
NPV,” Working paper
[3] Bernardo, A.E., H. Cai, and J. Luo, 2001, “Capital Budgeting and Compensation
with Asymmetric Information and Moral Hazard,” Journal of Financial Economics,
[4] Billett, M.T., and D.C. Mauer, 2003, “Cross-Subsidies, External Financing Constraints, and the Contribution of the Internal Capital Market to Firm Value,” Working paper. University of Iowa; forthcoming in Review of Financial Studies.
[5] Bushman, R. M., R.J. Indjejikian, and A. Smith, 1995, “Aggregate Performance
Measures in Business Unit Manager Compensation: The Role of Intrafirm Interdependencies,” Journal of Accounting Research, 33 Supplement, 101-128.
[6] Chevalier, J., 2000, “What do we know about Cross-subsidization? Evidence from
the Investment Policies of Merging Firms,” working paper, Yale University.
[7] Garcia, D., 2001, “Retained Equity, Investment Decisions and Private Information,”
working paper, Dartmouth College.
[8] Garcia, D., 2002, “Optimal Contracts with Privately Informed Agents and Active
Principals,” working paper, Dartmouth College.
[9] Gertner, R., D.S. Scharfstein, and J.C. Stein, 1994, “Internal versus External Capital Markets,” Quarterly Journal of Economics, 109, 1211-1230.
Information,” Journal of Finance, 51, 1139-1174.
[11] Harris, M., and A. Raviv, 1998, “Capital Budgeting and Delegation,” Journal of
Financial Economics, 50, 259-289.
[12] Harris, M., C.H. Kriebel, and A. Raviv, 1982, “Asymmetric Information, Incentives,
and Intrafirm Resource Allocation,” Management Science, 28, 604-620.
[13] Holmstrom, B., and P. Milgrom, 1987, “Aggregation and Linearity in the Provision
of Intertemporal Incentives,” Econometrica, 55, 597-619.
[14] Holmstrom, B., and J. Ricart i Costa, 1986, “Managerial Incentives and Capital
Management,” Quarterly Journal of Economics, 101, 835-860.
[15] Keating, A. S., 1997, “Determinants of Divisional Performance Evaluation Practices,” Journal of Accounting and Economics, 24, 243-274.
[16] Laffont, J.-J., and J. Tirole, 1986, “Using Cost Observation to Regulate Firms,”
Journal of Political Economy, 94, 614-641.
[17] Laffont, J.-J., and J. Tirole, 1993, A Theory of Incentives in Procurement and
Regulation, MIT Press, Cambridge.
[18] Lamont, O., 1997, “Cash Flow and Investment: Evidence from Internal Capital
Markets,” Journal of Finance, 52, 83-109.
[19] McAfee, R. P., and J. McMillan, 1987, “Competition for Agency Contracts,” RAND
Journal of Economics, 18, 296-307.
[20] Milgrom, P., and J. Roberts, 1992, Economics, Organizations and Management,
Prentice Hall, Englewood Cliffs.
43
[21] Mirrlees, J.A., 1971, “An Exploration in the Theory of Optimum Income Taxation,”
[23] Palia, D., 2000, “Corporate Governance and the Diversification Discount: Evidence
from Panel Data,” working paper, Rutgers University.
[24] Poterba, J., and L. Summers, 1992, “Time Horizons of American Firms: New
Evidence from a Survey of CEOs,” working paper, Harvard University.
[25] Rajan, R., H. Servaes, and L. Zingales, 2000, “The Cost of Diversity: The Diversification Discount and Inefficient Investment,” Journal of Finance, 55, 35-80.
[26] Shin, H., and R. Stulz, 1998, “Are Internal Capital Markets Efficient?”, Quarterly
Journal of Economics, 113, 531-552.
[27] Stein, J.C., 1997, “Internal Capital Markets and the Competition for Corporate
Resources,” Journal of Finance, 52, 111-133.
[28] Villalonga, 2003, “Diversification Discount or Premium: New Evidence from BITS
Establishment-Level Data,” Working Paper
[29] Whited, T., 2001, “Is it Inefficient Investment that Causes the Diversification Discount?,” Journal of Finance, 56, 1667-1692.
[30] Zhang, G., 1997, “Moral Hazard in Corporate Investment and the Disciplinary Role
of Voluntary Capital Rationing,” Management Science, 43, 737-750.
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Essay about Capital Budgeting
  • Capital Budgeting Essay
  • Essay about Capital Budgeting
  • Capital Budgeting Essay
  • Capital budgeting Essay
  • Capital Budgeting Essay
  • Capital Budgeting Essay
  • Essay on Capital Budgeting

Become a StudyMode Member

Sign Up - It's Free