Optimal Dynamic Capital Budgeting

61 Pages Posted: 19 Nov 2010 Last revised: 8 Jun 2016

Andrey Malenko

MIT Sloan School of Management

Date Written: June 7, 2016

Abstract

I study optimal design of a dynamic capital allocation process in an organization in which the division manager with empire-building preferences privately observes the arrival and properties of investment projects, and headquarters can audit projects at a cost. Under certain conditions, a budgeting mechanism with threshold separation of financing is optimal. Headquarters: (i) allocate a spending account to the manager and replenish it over time; (ii) set a threshold, such that projects below it are financed from the account, while projects above are financed fully by headquarters upon an audit. Further analysis studies when co-financing of projects is optimal and how the size of the account depends on past performance of projects.

Keywords: principal-agent, capital budgeting, internal capital markets, repeated interactions

JEL Classification: G31, D82, D86

Suggested Citation

Malenko, Andrey, Optimal Dynamic Capital Budgeting (June 7, 2016). Available at SSRN: https://ssrn.com/abstract=1710884 or http://dx.doi.org/10.2139/ssrn.1710884

Andrey Malenko (Contact Author)

MIT Sloan School of Management ( email )

100 Main Street
E62-619
Cambridge, MA 02142
United States
617-225-9301 (Phone)

HOME PAGE: http://www.mit.edu/~amalenko

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