Multi-Stage Capital Budgeting with Delayed Consumption of Slack
Management Science, 2012
30 Pages Posted: 2 Jul 2012
Date Written: July 2, 2012
Capital budgeting frequently involves multiple stages at which firms can continue or abandon ongoing projects. In this paper, we study a project requiring two stages of investment. Failure to fund Stage 1 of the investment precludes investment in Stage 2, whereas failure to fund Stage 2 results in early termination. In contrast to the existing literature, we assume that the firm can limit the manager’s informational rents with the early termination of the project. In this setting, we find that the firm optimally commits to a capital allocation scheme whereby it forgoes positive NPV projects at Stage 1 (capital rationing), while at Stage 2, depending on the manager’s previous report, it sometimes implements projects with a negative continuation NPV but in other situations forgoes implementing projects with positive continuation NPVs.
Keywords: Resource Allocation, Capital Budgeting, Rationing, Adverse Section, Dynamic Rents
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