61 Pages Posted: 19 Nov 2010 Last revised: 8 Jun 2016
Date Written: June 7, 2016
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: Suggested Citation
By Lin Cong
By Haoxiang Zhu