Capital budgeting and managerial empire building

I examine how a company's headquarters use an empire-building manager's report about decision-relevant private information to make capital budgeting decisions and compensate the manager. To this end, I construct a model comprising the headquarters (principal) and the manager (agent), who reports on the investment project's expected profitability. I identify the optimal investment sizes and compensation payments, where the headquarters trade off managerial information rents - arising from empire-building benefits inducing the manager to favour overinvestment - for investment efficiency. The headquarters counteract the manager's desire for overinvestment with investment distortions in the form of underinvestment (or overinvestment) for a high (or low) expected profitability. Due to these distortions, the expected compensation is not monotone in the level of empire-building benefits. Unlike previous capital budgeting studies, in this study, I show that managerial empire-building benefits can multi-directionally affect companies' optimal capital budgeting decisions and related compensation schemes.

Automated summary

This study examines how a company's headquarters make capital budgeting decisions and compensate managers based on their reports of decision-relevant private information. The findings show that managerial empire-building benefits can affect companies' optimal capital budgeting decisions, and the headquarters counteract the manager's desire for overinvestment through investment distortions.