Optimal Capital Allocation Using RAROC and EVA

44 Pages Posted: 11 Sep 1998

See all articles by Neal Stoughton

Neal Stoughton

Vienna University of Economics and Business; Vienna Graduate School of Finance (VGSF)

Josef Zechner

Vienna University of Economics and Business

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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.

Keywords: capital, allocation, risk, management, equity

JEL Classification: G21, G31, G32

Suggested Citation

Stoughton, Neal M. and Zechner, Josef, Optimal Capital Allocation Using RAROC and EVA. Journal of Financial Intermediation, Forthcoming. Available at SSRN: https://ssrn.com/abstract=118208 or http://dx.doi.org/10.2139/ssrn.118208

Neal M. Stoughton (Contact Author)

Vienna University of Economics and Business ( email )

Austria

Vienna Graduate School of Finance (VGSF) ( email )

Austria

Josef Zechner

Vienna University of Economics and Business ( email )

Welthandelsplatz 1
Vienna, Wien A-1019
Austria

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