Capital Budgeting and Compensation with Asymmetric Information and Moral Hazard¤ Antonio E. Bernardo Anderson School of Management at UCLAy

We consider optimal capital allocation and managerial compensation mechanisms for decentralized ̄rms when division managers have an incentive to misrepresent project quality and to minimize privately costly but value-enhancing e®ort. We show that in the optimal mechanism ̄rms always underinvest in capital relative to a naive application of the net present value (NPV) rule. We make a number of novel cross-sectional predictions about the severity of the underinvestment problem and the composition of managerial compensation contracts. We also ̄nd that ̄rms will optimally give greater performance-based pay (at the expense of ̄xed wages) to managers of higher quality projects to mitigate the incentive for managers to overstate project quality. Thus, managers may receive greater performancebased pay because they manage higher-quality projects, not that greater performance-based pay causes ̄rm value to increase. ¤We thank an anonymous referee, Bhagwan Chowdhry, Diego Garcia, Matthias Kahl, Eric Talley, Ivo Welch and seminar participants at UC Berkeley, Chicago, Hebrew University, Humboldt University, London Business School, Oxford, and Tel Aviv University for helpful comments. All errors are ours. yCorresponding author: 110 Westwood Plaza Box 951481, Los Angeles, CA, 90095-1481. tel: (310) 825-2198. fax: (310) 206-5455. e-mail: [email protected]