Working Paper: NBER ID: w1213
Authors: Robert A. Taggart Jr.
Abstract: It is common practice for firms to ration capital funds to their divisions, rather than set a price and let the divisions use as much as they want. This appears to be true even when the overall firm faces no rationing in the capital market. This paper offers an interpretation of this phenomenon based on Martin Weitzman's "Prices vs. Quantities" model. It is found that a rationing systemis advantageous when division managers do not perceive the full consequences of their investment decisions for the firm as a whole. By contrast, a pricing system for allocating capital among divisions would be favored when the division managers possess valuable information that cannot be costlessly communicated to headquarters. It is then argued that actual capital budgeting practice in many firms reflects a mixture of these two systems and can thus be interpreted as an attempt to reap both kinds of benefits at once.
Keywords: capital allocation; multidivision firms; hurdle rates; budgets; capital budgeting
JEL Codes: G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lack of awareness (D83) | preference for budget systems (H61) |
| valuable information cannot be communicated (D83) | preference for pricing system (hurdle rates) (H43) |
| divisional biases in forecasting (C53) | suboptimal investment decisions (G11) |
| suboptimal investment decisions (G11) | overall firm performance (L25) |
| mixed system (hurdle rates and budgets) (H60) | improved decision-making outcomes (D91) |
| reliability of divisional information (L15) | choice between systems (P50) |
| high variance in forecasts (G17) | preference for budget systems (H61) |
| low variance in forecasts (G17) | preference for hurdle rates (G11) |