Intrafirm capital allocation and managerial compensation

Finance

IFA Working Paper

1996

Motivated by interesting recent developments in the interaction of capital budgeting and intrafirm managerial compensation schemes, we develop an agency model in which managers privately observe capital productivity prior to requesting capital funds and contribute unobserved effort to the project. The Executive Committee responds to capital requests with an allocation of capital and a compensation scheme. Recognising the moral hazard inherent in the substitutability between managerial effort and capital, the optimal capital allocation and compensation system awards a capital level commensurate with its reported productivity and charges the manager in his compensation contract for the capital employed at a rate that mitigates his tendency to substitute financial capital for labour capital. Mangers with higher-productivity capital gain bargaining leverage and are allowed to share in the project gains as a means of resolving their tendency to misreport. However, when the Executive Committee's time is both essential to the project and constrained, capital rationing is a consequence, thereby offering the Executive Committee its own bargaining leverage. The resulting capital charge for a manager with higher-productivity capital now increases and moves closer to the rate that prevails under symmetric information. We also discuss how our analysis sheds light on the recent real-world developments in capital allocation and compensation schemes that motivated the paper.

Institute of Finance and Accounting

FIN 238

IFA Working Paper

No