Long-Term Capital Budgeting and Incentive Mechanism

Abstract

We characterize the optimal dynamic mechanism for capital budgeting and managerial compensation. The division manager privately observes the project productivity at each point in time as well as an initial signal that governs the productivity evolution. We show that the optimal allocation can be implemented by a simple mechanism with a one-time report of the initial signal. In the simple mechanism, the headquarters delegates the investment decisions to the manager and finances the capital expenditure by tying the budget to a linear compensation scheme. The project growth and the power of incentives depend on how the initial signal affects the future types.

Keywords: Capital Budgeting, Dynamic Mechanism Design, Managerial Compensations, Adverse Selection, Moral Hazard, Internal Capital Market

JEL Classification: D82, G31