Dynamic Resource Allocation with Hidden Volatility
55 Pages Posted: 23 Nov 2016 Last revised: 18 Jan 2021
Date Written: February 2, 2020
We study a firm's internal resource allocation using a dynamic principal-agent model with endogenous cash flow volatility. The principal supplies the agent with resources for productive use, but the agent has private control over both project volatility and resource intensity and may misallocate resources to obtain private benefits. The optimal contract can yield either overly risky or overly prudent project selection. It can be implemented with a constant pricing schedule (i.e., a static, decentralized, linear mechanism), giving the agent control over the resource quantities, project risk, and agent's equity share. The implementation rationalizes the use of hurdle rates above a firm's cost of capital and transfer prices above marginal cost, while showing that hurdle rates or transfer prices may not vary with the agent’s risk choice.
[The SSRN version includes the Internet Appendix]
Keywords: capital budgeting, transfer pricing, dynamic contracting, volatility control, cost of capital
JEL Classification: G31, D86, G34
Suggested Citation: Suggested Citation