American Accounting Association

AUGUST 6-10, 2011  •  DENVER, COLORADO

Session Title: Budgeting
Presentation Date: Wednesday August 10, 2011
Presentation Time: 10:15 am-11:45 am

Multi-Stage Resource Allocation under Asymmetric Information

Stanley Baiman, University of Pennsylvania
Mirko Heinle, University of Pennsylvania
Richard Saouma, Anderson School, UCLA

ABSTRACT: Investments frequently involve multiple rounds of funding; however, traditional models of the capital allocation process have considered either single-period/single-project models or multi-period models in which the investments each period are independent. In contrast, we examine a single-period but multi-stage model in which, at Stage 1, a manager proposes an initial project (or experiment) which the firm either accepts or rejects. If the project is initially accepted, its continuation value becomes known to the firm and manager at the end of Stage 1, at which point the firm determines whether or not to continue the project in Stage 2. We show that in this setting, the firm optimally commits to a capital allocation scheme that exhibits underinvestment at Stage 1, but exhibits instances of both over and underinvestment at Stage 2. That is, at Stage 1 the firm foregoes positive NPV projects, while at Stage 2 it implements negative NPV projects in some instances and foregoes implementing positive NPV projects in others. We provide further characterization of the optimal capital budgeting process and comparative statics.

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