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Project Evaluation and Control in Decentralized Firms: Is Capital Rationing Always Optimal?

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  • Tae-Young Paik

    (Department of Accounting, Sung Kyun Kwan University, Seoul, Korea)

  • Pradyot K. Sen

    (School of Management, State University of New York at Buffalo, Buffalo, New York 14620)

Abstract

When capital investments are made in an agency setting, we show that, even without risk considerations, capital rationing need not be the only rational outcome. We analyze a principal-agent model with risk neutrality and with two productive inputs: the agent's efforts and capital investment. The two inputs can be either economic complements or substitutes. The agent has pre-contract private information about his own type. The output is measured with an additive noise. We show that when the two inputs are substitutes, the optimal solution entails a marginal capital rationing. But when the two inputs are complements, then either a marginal capital rationing or a marginal leniency could be the optimal response. Our results, therefore, provide an explanation for why firms may employ a capital rationing for a project that may increase manufacturing complexity and hence may reduce (managerial) labor productivity, yet employ a less strict criterion for evaluating a productivity-enhancing project. This result contrasts with earlier results where only a capital rationing is shown to be optimal.

Suggested Citation

  • Tae-Young Paik & Pradyot K. Sen, 1995. "Project Evaluation and Control in Decentralized Firms: Is Capital Rationing Always Optimal?," Management Science, INFORMS, vol. 41(8), pages 1404-1414, August.
    • Handle: RePEc:inm:ormnsc:v:41:y:1995:i:8:p:1404-1414
    DOI: 10.1287/mnsc.41.8.1404
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    References listed on IDEAS

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    Cited by:

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    5. Horan, Stephen M. & Johnsen, D. Bruce, 2008. "Can third-party payments benefit the principal?: The case of soft dollar brokerage," International Review of Law and Economics, Elsevier, vol. 28(1), pages 56-77, March.

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