Dynamic Capital Allocation and Managerial Compensation

Abstract

This paper proposes a dynamic theory of capital budgeting and managerial compensation when investment information is decentralized and the agent can obtain private benefit from inefficiently deploying capital. The firm may forgo positive NPV projects, distort pay-performance sensitivity downward, and induce lower investment. The optimal mechanism is to allocate capital and compensate the agent through a budgeting account whose balance reflects the firm's internal financial slack. The agency cost and firm policies all vary monotonically with the account balance. As the firm accumulates more financial slack, fewer projects are forgone, capital is allocated more efficiently to the selected projects, and the agent is provided steeper incentive. The model better explains the documented evidences that firm liquidity is positively correlated with incentive pay, and negatively correlated with investment hurdle rates.