Dynamic Capital Allocation and Managerial Compensation

This paper proposes a dynamic theory of capital budgeting and compensation when investment information is decentralized and division manager can inefficiently deploy capital. The incentive cost and firm policies vary monotonically with stored liquidity. After bad performances, liquidity is low, positive NPV projects are foregone, and incentive is distorted downward. Projects with high return and high incentive cost may be monitored. As performance improves, liquidity becomes higher, fewer projects are forgone or monitored, and steeper incentive is provided. The model better explains the documented evidences that firm liquidity is positively correlated with incentive pay, and negatively with investment hurdle rates