Controlling Investment Decisions: Hurdle Rates and Intertemporal Cost Allocation
University of California, Berkeley - Haas School of Business
Stefan J. Reichelstein
Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)
CESifo Working Paper Series No. 354
We examine alternative performance measures for a manager who has superior information about the profitability of an investment project and contributes to periodic operating cash flows through his efforts. We find that residual income based on a suitably chosen depreciation schedule is an optimal performance measure. To address the underlying agency problem, the charge for capital in the calculation of residual income must be based on a hurdle rate that exceeds the principal's cost of capital. We also establish that proper matching of periodic operating cash flows with a share of the initial investment cost (via depreciation charges) is essential if the performance measure is to support optimal incentive provisions for a sufficiently wide class of agency problems.
Number of Pages in PDF File: 39
JEL Classification: D82, D92, M41working papers series
Date posted: January 6, 2000
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