We consider optimal capital allocation and managerial compensation mechanisms for decentralized firms when division managers have an incentive to misrepresent project quality and to minimize privately costly but value-enhancing effort. We show that in the optimal mechanism firms always underinvest in capital relative to a naive application of the net present value (NPV) rule. We make a number of novel cross-sectional predictions about the severity of the underinvestment problem and the composition of managerial compensation contracts. We also find that firms will optimally give greater performance-based pay (at the expense of fixed wages) to managers of higher quality projects to mitigate the incentive for managers to overstate project quality. Managers may thus receive greater performance-based pay because they manage higher quality projects, not that greater performance-based pay causes firm value to increase.

We develop a model of a two-division firm in which the “strong” division has, on average, higher quality investment opportunities than the “weak” division. We show that, in the presence of agency and information problems, optimal effort incentives are less powerful and thus managerial effort is lower in the strong division. This leads the firm to bias its project selection policy against the strong division. The selection bias is more severe when there is a larger spread in the average quality of investment opportunities between the two divisions.