Capital Budgeting in Multi-Division Firms: Information, Agency, and Incentives

We consider 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. We then examine the extent to which capital allocation and managerial compensation schemes can be designed jointly to mitigate the information and incentive problems within the firm. We find that the firm underinvests in capital in both projects (relative to the first-best level), optimal managerial profit-sharing increases in the quality of both projects, and managers underinvest resources in both projects. Interestingly, the underinvestment problem in one project is less severe when the other project is higher quality. This effect will be stronger when the moral hazard problem is more acute and project returns are more highly correlated. We also predict that multi-division firms will invest more (less) than single-division firms when other divisions in the firm perform well (poorly)