Information Acquisition for Internal Capital Allocation and Executive Compensation

Abstract

We examine the benefits and costs of internal capital allocation with costly information acquisition by an executive officer in the headquarter of the multi-divisional firm. Then we characterize the optimal compensation scheme for the officer that maximizes the expected firm value. The performance-based pay provides incentives of the officer to acquire the information to allocate internal capital efficiently. However, if managers of divisions derive private benefits from the funds, the internal capital allocation between divisions hurt their effort incentives. As a result, if a variance of projects’ returns of divisions is small, high efforts of the officer to allocate internal capital reduces an expected firm value. The optimal compensation scheme suggests, in that situation, the CEO compensation should not depend on the performance of the firm. In addition, if the variance of projects' returns is sufficiently large, then a sensitivity of the performance-based pay to firm's profit is positively correlated in the variance and negatively correlated in the mean of projects' returns.