Dynamic Capital Budgeting, Compensation, and Security Design

Abstract

This thesis examines how various agency frictions affect corporate financing, capital budgeting, managerial compensation and investment in dynamic settings. In the internal capital budgeting process, the agency issues considered are (i) the division manager privately observes project arrival and quality, and (ii) he can divert allocated capital. The optimal capital budgeting and compensation policies are jointly designed to mitigate agency costs that are endogenously determined. When the division's financial slack is low, positive NPV investments are possibly forgone and manager's pay-performance sensitivity is kept small. When the division's financial slack is high, projects are funded more efficiently and steeper incentives are provided. In the process of external financing, the key friction considered is that the agent has persistent private information about firm performance. In the optimal contract, the firm is financed by outside equity and a credit line contingent on compliance with a cash flow covenant. The agent is compensated via a combination of equity and stock options. As the level of persistence increases, the agent holds less equity and more stock options; the investors hold more equity. Investment is possibly efficient in the constrained firm and is varying with cash flow in the unconstrained firm.