Capital Budgeting in Multidivision Firms: Information, Agency, and Incentives

We examine optimal capital allocation and managerial compensationin a firm with two investment projects (divisions) each runby a risk-neutral manager who can provide (i) (unverifiable)information about project quality and (ii) (unverifiable) accessto value-enhancing, but privately costly resources. The optimalmanagerial compensation contract offers greater performancepay and a lower salary when managers report that their projectis higher quality. The firm generally underinvests in capitaland managers underutilize resources (relative to first-best).We also derive cross-sectional predictions about the sensitivityof investment in one division to the quality of investment opportunitiesin the other division, and the relative importance of division-leveland firm-level performance-based pay in managerial compensationcontracts.     

Models of Capital Investments with Private Information and Incentives: a Selective Review

The purpose of this paper is to selectively review research that addresses capital budgeting decisions in settings characterized by dispersed information and incentive problems. The papers are theoretical; they formulate and analyze models that vary in the number of periods considered, the number of economic actors involved, and the number of alternative projects available. The aims of the review are to describe some of the formulations that have been studied, to highlight their key economic and mathematical properties, to reveal their common economic forces, and to collect and organize their basic results.     

Inflation and Capital Budgeting Decisions: a Comment

F. M. Wilkes has argued that unadjusted cash flows and monetary opportunity costs be used when evaluating capital projects in an inflationary environment (Journal of Business Finance, Volume 4, No. 3). His conclusions are, however, that alternative approaches to net present value are probably necessary, This note examines Wilkes' analysis and argues that his initial model, using net present value techniques, is acceptable in practice on the adoption of fairly conventional assumptions.     

Decision Processes, Agency Problems, and Information: An Economic Analysis of Capital Budgeting Procedures

Corporations use a variety of processes to allocate capital.This article studies the benefits and costs of several commonbudget procedures from the perspective of a model with agencyand information problems. Processes that delegate aspects ofthe decision to the agent result in too many projects beingapproved, while processes in which the principal retains theright to reject projects cause the agent to strategically distorthis information about project quality. We show how the choiceof a decision process depends on these two costs, and specificallyon severity of the agency problem, quality of information, andproject risk.     

The Role of Real Options in Capital Budgeting: Theory and Practice1

Most discussions of capital budgeting take for granted that discounted cash flow (DCF) and real options valuation (ROV) are very different methods that are meant to be applied in different circumstances. Such discussions also typically assume that DCF is “easy” and ROV is “hard”—or at least dauntingly unfamiliar—and that, mainly for this reason, managers often use DCF and rarely ROV. This paper argues that all three assumptions are wrong or at least seriously misleading. DCF and ROV both assign a present value to risky future cash flows. DCF entails discounting expected future cash flows at the expected return on an asset of comparable risk. ROV uses “risk‐neutral” valuation, which means computing expected cash flows based on “risk‐neutral” probabilities and discounting these flows at the risk‐free rate. Using a series of single‐period examples, the author demonstrates that both methods, when done correctly, should provide the same answer. Moreover, in most ROV applications—those where there is no forward price or “replicating portfolio” of traded assets—a “preliminary” DCF valuation is required to perform the risk‐neutral valuation. So why use ROV at all? In cases where project risk and the discount rates are expected to change over time, the risk‐neutral ROV approach will be easier to implement than DCF (since adjusting cash flow probabilities is more straightforward than adjusting discount rates). The author uses multi‐period examples to illustrate further both the simplicity of ROV and the strong assumptions required for a typical DCF valuation. But the simplicity that results from discounting with risk‐free rates is not the only benefit of using ROV instead of—or together with—traditional DCF. The use of formal ROV techniques may also encourage managers to think more broadly about the flexibility that is (or can be) built into future business decisions, and thus to choose from a different set of possible investments. To the extent that managers who use ROV have effectively adopted a different business model, there is a real and important difference between the two valuation techniques. Consistent with this possibility, much of the evidence from both surveys and academic studies of managerial behavior and market pricing suggests that managers and investors implicitly take account of real options when making investment decisions.     

The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom

We report the results of a survey of capital budgeting techniques used by United Kingdom firms. Where possible, the evidence is combined with data collected over a 22 year period to provide a basis for the discussion of causes of trends. We observe that there has been a substantial narrowing of the theory-practice gap in the use of project appraisal methods. The gap has also narrowed in other areas: the analysis of risk, inflation adjustment, capital budget preparation, WACC calculation and post-auditing. However, there are other elements of capital budgeting theory, e.g. probability and beta analysis which have been adopted by very few practising managers. We also discuss non-economic projects, capital rationing and hurdle rates.     

Managerial Incentives and Internal Capital Markets

Capital budgeting in multidivisional firms depends on the external assessment of the whole firm, as well as on headquarters' assessment of the divisions. While corporate headquarters may create value by directly monitoring divisions, the external assessment of the firm is a public good for division managers who, consequently, are tempted to free ride. As the number of divisions increases, the free‐rider problem is aggravated, and internal capital markets substitute for external capital markets in the provision of managerial incentives. The analysis relates the value of diversification to characteristics of the firm, the industry, and the capital market.     

Capital Structure, Compensation and Incentives

This article illustrates an incentive-aligning role of debtin the presence of optimal compensation contracts. Owing toinformation asymmetry, value-maximizing compensation contractsallow managerial rents following high investment outcomes. Themanager has an incentive to increase these rents by choosinginvestments that generate greater information asymmetry. Anaptly chosen debt level mitigates this incentive, because investmentsthat generate greater information asymmetry have more volatileoutcomes. The greater volatility would make the debt risky,causing the shareholders to focus on high outcomes and thereforecompensation contracts that reduce managerial rents. At theoptimum, the manager avoids opportunistic investments, and theshareholders offer value-maximizing compensation contracts.Empirically, the analysis predicts a negative relationship betweenleverage and market-to-book that is reversed at extreme market-to-bookratios, a negative relationship between leverage and profitability,a negative relationship between leverage and pay-for-performance,and a positive relationship between pay-for-performance andinvestment opportunities.