Project Selection, Income Smoothing, and Bayesian Learning

Capital rationing is an empirically well-documented phenomenon. This constraint requiresmanagers to make investment decisions between mutually exclusive investmentopportunities. In a multiperiod agency setting, this paper analyses accounting rules thatprovide managerial incentives for efficient project selection. In oder to motivate a shortsightedmanager to expend unobservable effort and to make efficient investme nt decisions,the principal sets up an incentive scheme based on residual income (e.g. EVATM).The paper shows that income smoothing generates a trade-off between agency costs resultingfrom differences in discount rates and the costs associated with the “congruity”of residual earnings.