Dynamic Resource Allocation with Hidden Volatility

55 Pages Posted: 23 Nov 2016 Last revised: 3 Mar 2020

See all articles by Felix Zhiyu Feng

Felix Zhiyu Feng

University of Washington - Michael G. Foster School of Business

Mark M. Westerfield

University of Washington

Date Written: February 2, 2020

Abstract

We study firms' 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 firms' 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

Feng, Felix and Westerfield, Mark M., Dynamic Resource Allocation with Hidden Volatility (February 2, 2020). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2874612 or http://dx.doi.org/10.2139/ssrn.2874612

Felix Feng

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

Mark M. Westerfield (Contact Author)

University of Washington ( email )

Box 353200
Seattle, WA 98195
United States

HOME PAGE: http://www.markwesterfield.com

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