We examine alternative performance measures for a manager who has superior information about the profitability of an investment project and who contributes to periodic operating cash flows through his efforts. We find that residual income based on a suitably chosen depreciation schedule is an optimal performance measure. To address the underlying asymmetric information problem, the capital charge rate in the calculation of residual income should be equal to the firm's hurdle rate, which is the critical internal rate of return below which the principal would not want to fund the project. This hurdle rate includes the compensation cost for the better informed manager and therefore exceeds the principal's cost of capital. We also show that residual income remains an optimal performance measure in settings where multiple divisions compete for scarce investment funds. In order to solve the resource allocation problem, the capital charge rate must then be increased to a competitive hurdle rate.
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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number
CESifo Working Paper No. 354.
Length: Date of creation: 2000 Date of revision: Handle: RePEc:ces:ceswps:_354
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Find related papers by JEL classification: D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information D92 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Firm Choice and Growth, Investment, or Financing M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting
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