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

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

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June 20, 2003

Jiang Luo

Hongbin Cai

Antonio E. Bernardo

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


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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.

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