Project Evaluation and Control in Decentralized Firms: Is Capital Rationing Always Optimal?

Tae-Young Paik and Pradyot K. Sen
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Tae-Young Paik: Department of Accounting, Sung Kyun Kwan University, Seoul, Korea
Pradyot K. Sen: School of Management, State University of New York at Buffalo, Buffalo, New York 14620

Management Science, 1995, vol. 41, issue 8, 1404-1414

Abstract: When capital investments are made in an agency setting, we show that, even without risk considerations, capital rationing need not be the only rational outcome. We analyze a principal-agent model with risk neutrality and with two productive inputs: the agent's efforts and capital investment. The two inputs can be either economic complements or substitutes. The agent has pre-contract private information about his own type. The output is measured with an additive noise. We show that when the two inputs are substitutes, the optimal solution entails a marginal capital rationing. But when the two inputs are complements, then either a marginal capital rationing or a marginal leniency could be the optimal response. Our results, therefore, provide an explanation for why firms may employ a capital rationing for a project that may increase manufacturing complexity and hence may reduce (managerial) labor productivity, yet employ a less strict criterion for evaluating a productivity-enhancing project. This result contrasts with earlier results where only a capital rationing is shown to be optimal.

Keywords: project evaluation; capital rationing; agency; pre-contract private information (search for similar items in EconPapers)
Date: 1995
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Citations: View citations in EconPapers (5)

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