Capital Budgeting and Compensation with Asymmetric Information and Moral Hazard

37 Pages Posted: 1 Oct 2000

See all articles by Antonio E. Bernardo

Antonio E. Bernardo

University of California, Los Angeles (UCLA) - Finance Area

Hongbin Cai

Peking University - Guanghua School of Management

Jiang Luo

Hong Kong University of Science & Technology (HKUST) - Department of Finance

Date Written: July 17, 2000

Abstract

We consider optimal capital allocation and managerial compensation mechanisms for decentralized firms when division managers have an incentive to misrepresent project quality and to minimize privately costly but value-enhancing effort. We show that in the optimal mechanism firms always under invest in capital relative to a naive application of the net present value (NPV) rule. We make a number of novel cross-sectional predictions about the severity of the under investment problem and the composition of managerial compensation contracts. We also find that firms will optimally give greater performance-based pay (at the expense of fixed wages) to managers of higher quality projects to mitigate the incentive for managers to overstate project quality. Thus, managers may receive greater performance-based pay because they manage higher-quality projects, not that greater performance-based pay causes firm value to increase.

Suggested Citation

Bernardo, Antonio E. and Cai, Hongbin and Luo, Jiang, Capital Budgeting and Compensation with Asymmetric Information and Moral Hazard (July 17, 2000). Available at SSRN: https://ssrn.com/abstract=242690 or http://dx.doi.org/10.2139/ssrn.242690

Antonio E. Bernardo (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2198 (Phone)
310-206-5455 (Fax)

Hongbin Cai

Peking University - Guanghua School of Management ( email )

Peking University
Beijing, Beijing 100871
China

Jiang Luo

Hong Kong University of Science & Technology (HKUST) - Department of Finance ( email )

Clear Water Bay, Kowloon
Hong Kong

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