Long-Term Capital Budgeting Mechanism in Multidivision Firms

Abstract

We study the optimal dynamic mechanism for capital budgeting and managerial compensation in a firm that consists of two divisions. Division managers privately observe the characteristics of their own project, which govern the evolution of the project types, and the project’s subsequent profitability. At the same time, managers supply costly efforts to run the projects. The optimal mechanism incorporates the distortion driven by persistent private information and the production complementarity among the divisions. The headquarters should commit to investment policy that excludes or terminates projects, and controls the growth rate and volatility of project scales. With proportional distortions, the investment for good projects grows faster but is more volatile. In addition, we show that a linear contract implements the optimal investment and effort policy in an ex-post equilibrium, and the evolution of the power of incentives depends on the nature of initial private information. When a manager's private information generates decreasing distortion, her pay-performance sensitivity grows stronger over time, and the headquarters provides incentives through firm-level pay instead of divisional-level pay.