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

27 Pages Posted: 6 Apr 2004 Last revised: 24 Sep 2008

See all articles by Robert A. Taggart

Robert A. Taggart

Boston College - Carroll School of Management; National Bureau of Economic Research (NBER)

Date Written: October 1983

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.

Suggested Citation

Taggart, Robert A., Capital Allocation in Mult-Division Firms: Hurdle Rates vs. Budgets (October 1983). NBER Working Paper No. w1213. Available at SSRN: https://ssrn.com/abstract=305589

Robert A. Taggart (Contact Author)

Boston College - Carroll School of Management ( email )

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Dept. of Finance
Chestnut Hill, MA 02467
United States
617-552-4113 (Phone)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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