Capital budgeting in multidivision firms: information, agency, and incentives

We examine optimal capital allocation and managerial compensation in a firm with two investment projects (divisions) each run by a manager who can provide (i) (unverifiable) information about the quality of either or both projects and (ii) (unverifiable) access to valuable resources that can enhance the cash flows of either or both projects. In our model, each manager’s optimal compensation contract is linear in the cash flows of both projects. The firm optimally provides more capital, greater performance pay, and a lower salary to a division manager when she reports (truthfully, in equilibrium) that her project is higher quality. The firm generally underinvests in capital and managers underinvest resources in both projects (relative to the first-best level). We derive numerous cross-sectional predictions about the severity of the underinvestment problem, the sensitivity of investment in one division to the cash flows and investment opportunities of other divisions, and the relative importance of division-level and firm-level performance-based pay. We also compare investment policies in multi-division firms to single-division firms.