Faculty of Economics and Business Administration Publications Database

Innovation, Endogenous Overinvestment, and Incentive Pay

Klein, Manuel
Volume: 38
Number: 4
Pages: 881 - 904
Month: November
ISSN-Print: 1756-2171
Link External Source: Online Version
Year: 2007

We analyze how two key managerial tasks interact: that of growing the business through creating new investment opportunities and that of providing accurate information about these opportunities in the corporate budgeting process. We show how this interaction endogenously biases managers toward overinvesting in their own projects. This bias is exacerbated if managers compete for limited resources in an internal capital market, which provides us with a novel theory of the boundaries of the firm. Finally, managers of more risky and less profitable divisions should obtain steeper incentives to facilitate efficient investment decisions.