Internal financing, managerial compensation and multiple tasks

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 short-term profitability, thus generating greater immediate cash-flow, or to improve long-term perspectives. When both types of effort are observable, low productivity firms end up using internal funds, while high productivity 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. In such cases financing switches back and forth between internal and external funds as the quality of the project increases. However, when the effort to improve long-term protability is very effective the optimal financial policy is monotonic even under incomplete information.