"Cost of capital" in residual income for performance evaluation

We consider a setting in which a firm uses residual income to motivate a manager's investment decision. Textbooks often recommend adjusting the residual income capital charge for market risk, but not for firm-specific risk. We demonstrate two basic flaws in this recommendation. First, the capital charge should not be adjusted for market risk. Charging a market risk premium results in "double" counting because a risk-averse manager will personally consider this risk. Second, while investors can avoid firm-specific risk through diversification, a manager cannot. If the manager faces significant firm-specific risk at the time he makes his investment decision, then it is optimal to charge him less than the riskless return so as to partially offset his reluctance to undertake risky investments. On the other hand, the manager will vary his investment decisions with the pre-decision information he receives, which accentuates his compensation risk, and the firm must compensate him for bearing this additional risk. Hence, if the manager will receive relatively precise pre-decision information, then it is optimal to charge him more than the riskless return to reduce the variability of his investment decisions.