Sabotage in Capital Budgeting: The Effects of Control and Honesty on Investment Decisions

Abstract

This study examines the sabotage of feasible investments in capital budgeting in response to hurdle contracts as a means of formal control. Managers sabotage investments by falsely claiming that the investment misses the hurdle although it does not. We develop an analytical model and conduct a laboratory experiment to examine factors that drive or inhibit sabotage. Our results show that managers sabotage investments to reciprocate the distrust that the firm’s choice of the hurdle contract signals to them. Sabotage is thus largely driven by negative reciprocity. Conversely, budget requests that require factual assertions activate managers’ preference for honesty, which inhibits them from misreporting information in order to sabotage investments. Interestingly, we find an interaction between honesty and negative reciprocity: honesty suppresses negative reciprocity and therefore reduces sabotage not only directly but also indirectly. Our findings highlight sabotage as a hidden cost of control in participative budgeting. They also show that honesty, in addition to eliciting more truthful information, has an ethical spill-over effect as it suppresses negative reciprocity. Our findings warn firms to consider sabotage as a cost of control in capital budgeting.