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Optimal Capital Allocation Using RAROC(tm) and EVA

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  • Stoughton, Neal
  • Zechner, Josef

Abstract

This Paper analyses firms’ capital allocation decisions when optimal capital structure is linked to the risk of underlying assets and when equity capital is costly and cannot be raised instantaneously. In the model, division managers receive private information and authority is delegated to them over risky project choices. The optimal mechanisms are related to EVA compensation and RAROC performance measurement systems. In the optimal mechanism, position limits will be employed but are not always completely utilized. Hurdle rates reflect capital allocation through a division-specific capital structure. In the multidivisional context the optimal capital allocation mechanism incorporates valuable externalities leading to overall firm EVA maximization.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4169.

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Date of creation: Jan 2004
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Handle: RePEc:cpr:ceprdp:4169

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Keywords: banking; capital budgeting; financial institutions; investment policy;

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Cited by:
  1. Buch, Arne & Dorfleitner, Gregor & Wimmer, Maximilian, 2011. "Risk capital allocation for RORAC optimization," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 3001-3009, November.
  2. Carlo Alberto, Magni, 2008. "Splitting Up Value: A Critical Review of Residual Income Theories," MPRA Paper 10506, University Library of Munich, Germany.
  3. Mierzejewski, Fernando, 2008. "The Allocation of Economic Capital in Opaque Financial Conglomerates," MPRA Paper 9432, University Library of Munich, Germany.
  4. Cipollini, Andrea & Fiordelisi, Franco, 2012. "Economic value, competition and financial distress in the European banking system," Journal of Banking & Finance, Elsevier, vol. 36(11), pages 3101-3109.
  5. Roper, Andrew H. & Ruckes, Martin E., 2012. "Intertemporal capital budgeting," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2543-2551.
  6. Baule, Rainer, 2014. "Allocation of risk capital on an internal market," European Journal of Operational Research, Elsevier, vol. 234(1), pages 186-196.
  7. Hałaj, Grzegorz, 2013. "Optimal asset structure of a bank - bank reactions to stressful market conditions," Working Paper Series 1533, European Central Bank.
  8. Alex Ferrer & José Casals & Sonia Sotoca, 2014. "Linking the problems of estimating and allocating unconditional capital," Documentos de Trabajo del ICAE 2014-13, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.
  9. Ghiselli Ricci, Roberto & Magni, Carlo Alberto, 2009. "Axiomatization of residual income and generation of financial securities," MPRA Paper 14438, University Library of Munich, Germany.
  10. Trenca Ioan & Zoicas-Ienciu Adrian, 2010. "The Correlation Between The Market Risk And The Liquidity Risk In The Romanian Banking Sector," Annals of Faculty of Economics, University of Oradea, Faculty of Economics, vol. 1(1), pages 437-442, July.
  11. Christian Bach, 2011. "Conservatism in Corporate Valuation," CREATES Research Papers 2011-32, School of Economics and Management, University of Aarhus.
  12. Mencía, Javier, 2012. "Assessing the risk-return trade-off in loan portfolios," Journal of Banking & Finance, Elsevier, vol. 36(6), pages 1665-1677.
  13. Konstantinos J. Liapis, 2010. "The Residual Value Models: A Framework for Business Administration," European Research Studies Journal, European Research Studies Journal, vol. 0(1), pages 83-102.

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