The capital budgeting process in large corporations receives considerable attention by the top management. There are two elements which make the selection of investment projects difficult. First, knowledge about the profitability of different projects is decentralized, as division managers usually have an informational advantage over the firm’s headquarters. Second, when external financing is more costly than internal financing the Headquarters has also to worry about generating internally the cash-flow needed to finance the project.
The decentralization of information about investment project makes it necessary to provide incentives, monetary or otherwise, for truthful elicitation of information. This is a standard adverse selection, or hidden information, problem. The need for internal generation of cash flow also requires proper alignment of incentives. This can be seen as a moral hazard problem, in which divisional manager have to be provided incentives for allocating correctly their effort between activities aimed at improving the long-term investment prospects of the firm and activities aimed at immediate generation of cash-flow.
Providing the manager the incentives to report project quality truthfully and to exert appropriate effort may require the use of complex schemes to allocate capital. In particular, it may be optimal to deviate from the capital allocation prescribed by the simple NPV rule. Furthe rmore, in order to deal effectively with incentive problems, capital budgeting procedures have to be determined jointly with compensation schemes.
The literature has so far ignored two aspects that play a crucial role in the capital budgeting process. The first one is that capital budgeting procedures are commonly used in corporations with multiple divisions. Each division competes with the others to get a larger share of the funds allocated by headquarters, and competition for funds may exacerbate the incentive to misrepresent the project’s profitability by the division managers. The second complication is that a large fraction of the capital allocated to the divisions comes from the cash flow internally generated by the divisions themselves.
When division managers face the possibility that the cash flow that they have produced be allocated to a different division with a more profitable project, their incentives for short-term generation of cash-flow are reduced. In Brusco and Panunzi (2001) we have discussed how the reallocation of resources across divisions, although ex post profitable, may harm managerial incentives to exert effort and therefore decrease the ex ante value of the firm.
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Managerial Compensation and Capital Allocation in Conglomerate Firms
