Project Specific External Financing and Headquarters Monitoring Incentives

The paper analyzes the relationship between a firm's financing and its project incorporation decisions. It is shown that headquarters may have an incentive to carry out a new project within a subsidiary rather than within the existing firm. The project is partially financed through an external claim which is taken on by the subsidiary even though the parent corporation has sufficient funds to finance the project on its own. The reason for this is that reducing headquarters' claim on the project's cash flow may increase its incentive to monitor the quality of the project prior to making a continuation investment. This has positive incentive implications for the manager who is running the project