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Intertemporal Cost Allocation and Investment Decisions

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  • William P. Rogerson
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    Abstract

    This paper considers the profit-maximization problem of a firm that must make sunk investments in long-lived assets to produce output. It is shown that if per-period accounting income is calculated using a simple and natural allocation rule for investment, called the relative replacement cost (RRC) rule, under a broad range of plausible circumstances, the firm can choose the fully optimal sequence of investments over time simply by choosing a level of investment each period in order to maximize the next period's accounting income. Furthermore, in a model in which shareholders delegate the investment decision to a better-informed manager, it is shown that if accounting income based on the RRC allocation rule is used as a performance measure for the manager, robust incentives are created for the manager to choose the profit-maximizing sequence of investments, regardless of the manager's own personal discount rate or other aspects of the manager's personal preferences. (c) 2008 by The University of Chicago. All rights reserved..

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    Bibliographic Info

    Article provided by University of Chicago Press in its journal Journal of Political Economy.

    Volume (Year): 116 (2008)
    Issue (Month): 5 (October)
    Pages: 931-950

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    Handle: RePEc:ucp:jpolec:v:116:y:2008:i:5:p:931-950

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    Web page: http://www.journals.uchicago.edu/JPE/

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    Cited by:
    1. Maureen McNichols & Madhav V. Rajan & Stefan Reichelstein, 2014. "Conservatism Correction for the Market-To-Book Ratio and Tobin's q," CESifo Working Paper Series 4626, CESifo Group Munich.
    2. Stefan Reichelstein & Anna Rohlfing-Bastian, 2014. "Levelized Product Cost: Concept and Decision Relevance," CESifo Working Paper Series 4590, CESifo Group Munich.

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