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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.

Abstract:
Equity capital allocation plays a particularly important role for financial institutions such as banks, who issue equity infrequently but have continuous access to debt capital. In such a context this paper shows that EVA and RAROC based capital budgeting mechanisms have economic foundations. We derive optimal capital allocation under asymmetric information and in the presence of outside managerial opportunities for an institution with a risky and a riskless division. It is shown that the results extend in a consistent manner to the multidivisional case of decentralized investment decisions with a suitable redefinition of economic capital. The decentralization leads to a charge for economic capital based on the division's own realized risk. Outside managerial opportunities increase the usage of capital and lead to overinvestment in risky projects; at the same time more capital is raised but risk limits are binding in more states. An institution with a single risky division should base its hurdle rate for capital allocated on the cost of debt. In contrast, the hurdle rate tends to the cost of equity for a diversified multidivisional firm. The analysis shows that hurdle rates have a common component in contrast to the standard perfect markets result with division-specific hurdle rates.

capital, allocation, risk, management, equity

Abstract:
Financial institutions are facing increased pressure to enhance shareholder value. This has lead to the popularity of practical techniques such as EVA and RAROC. The major purpose of this study is to illustrate the interaction between incentive-based compensation and performance evaluation in a multiperiod setting. We demonstrate that while EVA can justifiably be used to incentivize managers to make better current investment decisions, performance measurement techniques such as RAROC help the firm to better assess abilities for the future. The model is applied to understand why hard position limits are employed as well as softer incentive contracts and what sort of termination standard should be used for the investment manager.

Abstract:
Compensation policy has become one of the most important ingredients of corporate governance. In this paper we take a new look at the issue, by contrasting the use of options with that of stock. We do this by integrating the repricing or resetting aspect of options with that of industrial structure. We show that industry competition may play an important role in dictating which form of compensation is optimal. When aggressive competition for key professional staff is an issue, the flexibility of options may actually become a disadvantage and therefore pure stock compensation may survive as an equilibrium. Thus compensation trends may be partly explained by trends in the nature of the competitive environment.

G30, D21, D43

Abstract:
Compensation policy has become one of the most important ingredients of corporate governance. In this paper we take a new look at the issue, by contrasting the use of options with that of stock. We do this by integrating the repricing or resetting aspect of options with that of industrial structure. We show that industry competition may play an important role in dictating which form of compensation is optimal. When aggressive competition for key professional staff is an issue, the flexibility of options may actually become a disadvantage and therefore pure stock compensation may survive as an equilibrium. Thus compensation trends may be partly explained by trends in the nature of the competitive environment.

Compensation, options, stock, product markets, competition, employees

Abstract:
Intermediaries such as financial advisers and funds of funds serve a vital role in the financial services industry as an interface between portfolio managers and investors. A large fractioon of their compensatioon is often provided through rebates or kickbacks from the portfolio manager rather than directly by their clients. In a model with ratioonal agents we provide an explanation for the widespread use of intermediaries and rebates in compensation practices. We also explore the effects of these arrangements on fund size, flows, performance and investor welfare. Intermediated funds will underperform direct channel funds based on net returns as well as gross returns. Rebates allow higher management fees to be charged, with the consequence that equilibrium fees and net returns are negatively related.

investment management, intermediation, investment adviser, kickback

Abstract:
Given recent public attention paid to high-flying internet IPOs such as Yahoo and Amazon.com, this paper explores a product market motive for going public. We develop a model where consumers look to the stock price to make inferences. The model predicts that only better quality firms will go public. Effects of IPO announcements on rival firms' stock prices are related to inferences of market size and market share. The model also predicts that the likelihood of "hot issue" markets depends on the distribution of market size uncertainty and the degree of network externalities present in consumer preferences.