Project Selection, Income Smoothing and Bayesian Learning

Abstract

The use of fixed capital budgets is an empirically well-documented phenomenon in business practice. Whensoever some profitable investment opportunities cannot be realized, managers have to make investment decisions between mutually exclusive investment opportunities. In a multiperiod agency setting this paper analyses accounting rules that provide managerial incentives for efficient project selection when a short-sighted manager is rewarded based on residual income. Before having access to profitable investment opportunities the agent has to expend unobservable effort. At each date the less informed principal observes a noisy cash flow signal which is informative about the agent's investment decision. By updating prior beliefs the principal faces a trade-off between agency costs resulting from differences in discount rates and the benefits resulting from the information content of the noisy cash flow signals.