Optimal Dynamic Capital Budgeting

I study optimal design of a dynamic capital allocation process in an
organization in which the division manager with empire-building preferences
privately observes the arrival and properties of investment projects, and
headquarters can audit projects at a cost. Under certain conditions, a
budgeting mechanism with threshold separation of financing is optimal.
Headquarters: (i) allocate a spending account to the manager and replenish
it over time; (ii) set a threshold, such that projects below it are financed
from the account, while projects above are financed fully by headquarters
upon an audit. Further analysis studies when co-financing of projects is
optimal and how the size of the account depends on past performance of
projects.

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