Firm Investment and Stakeholder Choices: A Top-Down Theory of Capital Budgeting

Abstract

This paper considers the optimal design of capital budgeting rules when the firm’s capital budgeting process involves the interaction of top executives, with private information and stakeholders (e.g., employees) whose motivation and efforts affect the likelihood of the firm’s success. In this setting, the decisions of top executives affect stakeholders’ inferences about firms’ prospects and as a result, influence their actions. Specifically, higher levels of investment expenditures indicate that a firm has promising prospects and induce stakeholders to take actions that contribute to the firm’s success. Within this framework we examine the role of commonly observed capital budgeting rules which not only play their traditional allocative role but also affect how private information is transmitted from the top down. As we show, the optimal capital budgeting mechanism is consistent with a number of commonly observed investment distortions such as capital rationing, investment rigidities, overinvestment, and inflated discount rates.

Keywords: Capital expenditures, budgeting rules, mechanism design