Opening the Black Box of Capital Investment: The Roles of Capital Expenditure Budget and Execution

Abstract

Prior research documents significant inefficiencies of corporate capital expenditures. However, a firm’s internal investment decision process remains mostly an empirical black box. Using manually collected data, we decompose the investment process into two stages: budgeting of capital expenditures and execution of the budget. Consistent with the theoretical prediction that boards use capital rationing in budgets to counter managerial empire building, we find that boards place restrictions on capital spending in investment budgets initially but allow managers to use additional capital for follow-up projects. While some managers use their discretions to incorporate economic news in their investment decisions, many others engage in empire building in the execution stage. We find more capital rationing and more opportunistic execution behavior in firms with lower accounting quality. These findings together support the existence of capital rationing in internal corporate investment process. Our study contributes to a better understanding of how firms make investment decisions internally and the important role of accounting quality.