Managerial Incentives and Capital Management

The paper shows how career concerns rather than effort aversion can induce a natural incongruity in risk preferences between managers and superiors. A model, based on learning about managerial talent, is developed to study second-best contractual remedies. We show that the optimal wage contract is an option of the value of the manager's human capital for insurance reasons and that consequently rationing of capital is often required to counterbalance the manager's resulting incentive to overinvest. Rationing is strictly superior to price decentralization, offering one reason for the prevalence of centralized capital budgeting procedures.