Controlling Investment Decisions: Depreciation- and Capital Charges
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 for Economic Research)
This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to the residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.
Number of Pages in PDF File: 43
Keywords: capital budgeting, residual income, depreciation, hurdle rate, agency problems
JEL Classification: M40, M41, M46, G31, J33, D82working papers series
Date posted: December 15, 2002
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