Capital Budgeting and Managerial Compensation: Incentive and Retention Effects

Posted: 25 Oct 2002

See all articles by Sunil Dutta

Sunil Dutta

University of California, Berkeley - Haas School of Business

Abstract

This paper considers an agency model in which a firm's manager receives private information about an investment project. The manager has unique skills that are essential for implementing the project, and he can pursue the project inside the firm or as an outside venture on his own. The firm's owner thus faces a potential managerial retention problem, where the severity of the retention problem depends on the project's outside viability. My analysis shows that if the managerial retention problem is not too severe, the owner can delegate the investment decision to the manager and use a residual-income-based bonus contract to give the manager incentives to work hard and make appropriate investment decisions. If the retention problem is severe, however, the owner must use an option-based compensation contract to retain the manager and provide him with appropriate incentives. I also establish that as the managerial retention problem becomes more severe, the owner reduces the rate of return, or hurdle rate, required to approve the investment project. These results predict that new-economy firms, in which managerial expertise is critical and yet mobile, are more likely to (1) include stock options in their managers' compensation contracts, and (2) apply lower hurdle rates for approving capital investments.

Keywords: capital investments, stock options, managerial retention, managerial incentives

JEL Classification: J33, M40, M46, G31, D82

Suggested Citation

Dutta, Sunil, Capital Budgeting and Managerial Compensation: Incentive and Retention Effects. Available at SSRN: https://ssrn.com/abstract=328941

Sunil Dutta (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

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