Residual Income-Based Compensation Plans for Controlling Investment Decisions Under Sequential Private Information

Abstract

Earlier literature has pointed to the effectiveness of residual income-type measures based on particular accrual accounting rules such as the relative benefit allocation rule. These performance metrics have been shown to generate desirable managerial incentives when investment decisions are delegated. This paper further attests to the robustness of these measures by extending the result to a sequential adverse selection model with an inherent real option (an option to abandon). In other words, as long as the residual income measures are judiciously constructed, neither private information nor the requirement to selectively exercise an option derails their use in this setting.sequential capital budgeting, residual income, accounting adjustments, sequential adverse selection problem

Residual income and value creation: An investigation into the lost-capital paradigm

“…This implies that value of inventory is c(1 + i) t−t * + t−t * k=0 (1 + i) k x t , with c=unit production cost, x t =ending inventory, t * = beginning of inventory buildup. The authors show that the optimal production and sales plan that maximizes the firm's NPV is also the one that maximizes the NPV of manager's bonus payments; in the case where the manager receives updated information about future revenues after the initial production decision, the residual income based on the lower-of-cost-or-market rule becomes the optimal incentive mechanism (see also Dutta and Zhang, 2002, on production incentives, and Pfeiffer and Schneider, 2007). Dutta and Reichelstein (2005) analyze several different transactions: multi-year construction contracts, long-term leases, asset disposals, research and development.…”

Multistage Capital Budgeting with Delayed Consumption of Slack

“…In both pa--pers, the principal makes a Stage 1 investment decision based on the manager's report and later makes her Stage 2 continuation decision based on information revealed at Stage 2. 5 The major difference be--tween our paper and Pfeiffer and Schneider (2007) concerns the informational rent. In Pfeiffer and Schneider (2007) the principal incurs an informational rent (and the manager consumes it) only if the project is continued.…”

“…5 The major difference be--tween our paper and Pfeiffer and Schneider (2007) concerns the informational rent. In Pfeiffer and Schneider (2007) the principal incurs an informational rent (and the manager consumes it) only if the project is continued. 6 In our model, the principal incurs the informational rent upfront at the time of the Stage 1 funding.…”

“…If funded, the manager's investigative or research work gener-- 5 The interim signal is privately observed by the manager in Pfeiffer and Schneider (2007), whereas it is publicly ob--served in our model. 6 Further, in Pfeiffer and Schneider (2007) the abandonment decision creates information in the sense that it al--lows the principal to perfectly observe the agent's subsequent effort choice. In contrast, in Arya and Glover (2003) abandonment destroys information about the agent's prior choice of effort.…”

“…The structure of our model is most closely related to that of Pfeiffer and Schneider (2007). In both pa--pers, the principal makes a Stage 1 investment decision based on the manager's report and later makes her Stage 2 continuation decision based on information revealed at Stage 2.…”