In Holmstrom (1982) an example is given, which shows that a manager’s concern for the value of his human capital will lead to a natural incongruity in risk-preferences between himself and the owners, even when no effort considerations are involved. In this paper we present a formal model of this channel of incongruity based on learning about managerial talent. We also explore the nature of an optimal incentive contract in the case where the manager may withhold but not misrepresent information about investment returns. The optimal contract is an option on the manager’s human capital value with a possible bonus for investing. The optimal investment rule accepts fewer investments than under the cost of capital — a commonly observed real world feature. Another phenomena the model helps explain is the extensive use of capital budgeting and rationing schemes in place of linear or non-linear price decentralization, which are shown to be less efficient modes of allocation.
JEL Classification: 026, 851, 512
Keywords: Incentives, Managerial incentives, Capital budgeting