Selection among Mutually Exclusive Investments with Managerial Private Information and Moral Hazard

Rick Antle, Peter Bogetoft and Andrew W. Stark
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Rick Antle: Yale School of Management
Andrew W. Stark: Manchester Business School

No 1997-06, CIE Discussion Papers from University of Copenhagen. Department of Economics. Centre for Industrial Economics

Abstract: We investigate the problem of selecting capital investments in an organizational context with asymmetric information. In a principal-agent model where a manager (agent) has superior information about the investment costs of n available mutually exclusive projects, we develop the owner´s (principal´s) optimal investment and compensation policies subject to the constraints created by the manager´s strategic behavior. The optimal policies take a simple form, and are defined by a handicapping scheme involving n cost targets, one for each of the possible projects. The optimal investment policy does not select the project with maximal, positive net present value (NPV). To limit the manager´s informational rents, projects with positive NPV may be forgone. Also, the project with maximal NPV is not always selected. To save on incentive costs, there will be tendency by to favour projects with less variation in costs. Furthermore, when the available projects are asymmetric ex ante, it may nevertheless be optimal to use an asymmetric policy.

Pages: 24 pages
Date: 1997-02
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