Controlling Investment Decisions: Depreciation- and Capital Charges

43 Pages Posted: 15 Dec 2002

See all articles by Sunil Dutta

Sunil Dutta

University of California, Berkeley - Haas School of Business

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

Multiple version iconThere are 2 versions of this paper

Date Written: February 2002

Abstract

This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to the residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.

Keywords: capital budgeting, residual income, depreciation, hurdle rate, agency problems

JEL Classification: M40, M41, M46, G31, J33, D82

Suggested Citation

Dutta, Sunil and Reichelstein, Stefan J., Controlling Investment Decisions: Depreciation- and Capital Charges (February 2002). Available at SSRN: https://ssrn.com/abstract=354701 or http://dx.doi.org/10.2139/ssrn.354701

Sunil Dutta (Contact Author)

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

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Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business ( email )

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650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

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