Innovation, Endogenous Overinvestment, and Incentive Pay

We analyze how two of the key tasks of (division) managers interact: the task to grow the business by creating new investment opportunities and the task to provide accurate information about these opportunities in the corporate budgeting process. We show how the interaction of these two tasks endogenously biases managers towards overinvesting in their own projects. This bias is further exacerbated if managers have to compete for limited corporate resources in an internal capital market. We find that only a sufficiently steep compensation scheme can mitigate or even overcome this bias. Our theory generates several novel implications linking the use of compensation schemes and corporate investment decisions