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Innovation, endogenous overinvestment, and incentive pay

Author: Inderst, Roman ; Klein, ManuelINSEAD Area: FinanceIn: Rand Journal of Economics, vol. 38, no. 4, winter 2007 Language: EnglishDescription: p. 881-904.Type of document: INSEAD ArticleNote: Please ask us for this itemAbstract: 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.
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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.

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