“Internal Financing, Managerial Compensation and Multiple Tasks” by Professor Sandro Brusco
Stony Brook University
We study the optimal capital budgeting policy of a firm taking into account the choice between internal and external financing. The manager can dedicate effort either to increase the short-term profitability of the firm, thus generating greater immediate cash-flow, or to improve long-term perspectives. When both types of effort are observable, low return firms end up using internal funds, while high return firms use external capital markets. When effort to boost short-term cash flow is observable, while effort to boost long-term profitability is not, non-monotonic policies may be optimal, that is. financing switches back and forth between internal and external funds as the quality of the project increases.