Capital rationing and managerial retention: the role of external capital∗

In modern businesses, firms face new challenges of managerial retention in capital budgeting process. We consider a model in which a manager privately observes the capital productivity of a project and has access to multiple outside financing options. We show that if the manager can obtain funding from either internal or external capital (but not both), the firm may exclude highly profitable investment projects but fund those projects that have moderate capital productivity, even when there is no limit on capital allocation. Furthermore, the firm may voluntarily impose capital rationing in order to keep the projects within the firm, even though it has sufficient capital to fund such profitable projects. However, if the firm can utilize both the internal and external capital, highly profitable projects are always retained and the voluntary capital rationing is not optimal. Our analysis identifies testable empirical predictions on the association between capital budgeting and external capital.