Controlling Investment Decisions: Hurdle Rates and Intertemporal Cost Allocation

Abstract:     
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.

JEL Classifications: D82, D92, M41

Working Paper Series