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Capital Allocation in Mult-Division Firms: Hurdle Rates vs. Budgets

  • Robert A. Taggart, Jr.
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    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.

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    File URL: http://www.nber.org/papers/w1213.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1213.

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    Date of creation: Oct 1983
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    Publication status: published as Taggart, Robert A., Jr. "Capital Allocation in Multi-Division Firms: Hurdle Rates vs. Budgets," Journal of Financial Research, Vol. 10, No. 3, Fall 1987, pp. 177-189.
    Handle: RePEc:nbr:nberwo:1213
    Note: ME
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
    Phone: 617-868-3900
    Web page: http://www.nber.org
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    1. Weitzman, Martin L, 1974. "Prices vs. Quantities," Review of Economic Studies, Wiley Blackwell, vol. 41(4), pages 477-91, October.
    2. Carleton, Willard T, 1969. "Linear Programming and Capital Budgeting Models: A New Interpretation," Journal of Finance, American Finance Association, vol. 24(5), pages 825-33, December.
    3. M. Therese Flaherty, 1981. "Prices Versus Quantities and Vertical Financial Integration," Bell Journal of Economics, The RAND Corporation, vol. 12(2), pages 507-525, Autumn.
    4. Weingartner, H Martin, 1977. "Capital Rationing: n Authors in Search of a Plot," Journal of Finance, American Finance Association, vol. 32(5), pages 1403-31, December.
    5. M. Harris & C. H. Kriebel & A. Raviv, 1982. "Asymmetric Information, Incentives and Intrafirm Resource Allocation," Management Science, INFORMS, vol. 28(6), pages 604-620, June.
    6. Weitzman, Martin L, 1978. "Optimal Rewards for Economic Regulation," American Economic Review, American Economic Association, vol. 68(4), pages 683-91, September.
    7. Bower, Richard S & Lessard, Donald R, 1973. "An Operational Approach to Risk-Screening," Journal of Finance, American Finance Association, vol. 28(2), pages 321-37, May.
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