capital budgeting in multidivision firms information agency and incentives author s bernardo antonio e cai hongbin luo jiang abstract we consider a firm with two investment projects divisions each run by a manager who can provide i unverifiable information about the quality of either or both projects and ii unverifiable access to valuable resources that can enhance the cash flows of either or both projects we then examine the extent to which capital allocation and managerial compensation schemes can be designed jointly to mitigate the information and incentive problems within the firm we find that the firm underinvests in capital in both projects relative to the first best level optimal managerial profit sharing increases in the quality of both projects and managers underinvest resources in both projects interestingly the underinvestment problem in one project is less severe when the other project is higher quality this effect will be stronger when the moral hazard problem is more acute and project returns are more highly correlated we also predict that multi division firms will invest more less than single division firms when other divisions in the firm perform well poorly

internal capital markets and the competition for corporate resources this article examines the role of corporate headquarters in allocating scarce resources to competing projects in an internal capital market unlike a bank headquarters has control rights that enable it to engage in winner picking the practice of actively shifting funds from one project to another by doing a good job in the winner picking dimension headquarters can create value even when it cannot help at all to relax overall firm wide credit constraints the model implies that internal capital markets may sometimes function more efficiently when headquarters oversees a small and focused set of projects this article analyzes the process by which internal capital markets channel limited resources to different uses inside a company in so doing it seeks to address two related sets of questions first what is the fundamental economic rationale for creating an internal capital market that is under what circumstances can it make sense to combine several technologically distinct projects under one roof and have them seek funding from corporate headquarters as opposed to setting them up as stand alone companies that each raise external financing on their own second given this rationale what is the optimal size and scope of an internal capital market should headquarters be involved in funding a large number of projects or just a few and should these projects be unrelated to one another or in similar lines of business the answers to both sets of questions flow from the insight that in a credit constrained setting where not all positive npv projects can be financed headquarters can create value by actively reallocating scarce funds across projects for example the cash flow generated by one division s activities may be taken and spent on investment in another division where the returns are higher or alternatively one division s assets may be used as collateral to raise financing that is then diverted to the other division simply put individual projects must compete for the scarce funds and headquarters job is to pick the winners and losers in this competition

discrete equilibrium price dispersion an explicit solution of an equilibrium model with price setting firms and searching customers makes possible a number of comparativestatics predictions about how cost differences among firms search costs of customers and taxes will affect the mean and variance of the distribution of market prices another implication of the model is that a firm s demand depends on the difference between its price and the average price in the market

capital budgeting and delegation abstract as part of our ongoing research into capital budgeting processes as responses to decentralized information and incentive problems we focus in this paper on when a level of a managerial hierarchy will delegate the allocation of capital across projects and time to the level below it in our model delegation is a way to save on costly investigation of proposed projects therefore it is more extensive the larger are the costs of such investigations this delegation takes advantage of the fact that the lower level manager s preferences are assumed to be similar though not identical to those of the higher level

the effects of firm optimizing behaviour in matching models this paper considers a matching model of which the search behaviour of jovanovic 1979 and albrecht and jovanovic 1984 are special cases the nature of the generality is that each unemployed worker has more information than firms about his average productivity this results in wage offers falling over the length of an unemployment spell because a long spell is a signal of lower than average productivity the results of the paper are similar to the scarring effect of heckman and borjas 1980 and greenwald 1986 and the discouraged worker effect of schweitzer and smith 1974

information the cost of credit and operational eﬃciency an empirical study of microfinance we provide direct evidence on the impact of asymmetric information on both financing and operating activities through a study of credit evaluations of microfinance institutions mfis we employ a regression discontinuity model that exploits the eligibility criteria of an evaluation subsidy ofered by a nonprofit consortium evaluations dramatically cut the cost of financing this efect is strongest for commercial lenders and for short term mfi lender relationships the impact of evaluations on the supply of finance is mixed evaluated mfis lend more efciently extending more loans per employee the author 2010 published by oxford university press on behalf of the society for financial studies all rights reserved for permissions please e mail journals permissions oxfordjournals org oxford university press

optimal dynamic capital budgeting i study optimal design of a dynamic capital allocation process in an organization in which the division manager with empire building preferences privately observes the arrival and properties of investment projects and headquarters can audit projects at a cost under certain conditions a budgeting mechanism with threshold separation of financing is optimal headquarters 1 allocate a spending account to the manager and replenish it over time 2 set a threshold such that projects below it are financed from the account while projects above are financed fully by headquarters upon an audit further analysis studies when co financing of projects is optimal and how the size of the account depends on past performance of projects

an equilibrium model of search unemployment this paper develops a simple general equilibrium model with sequential search in which a nondegenerate wage offer distribution is endogenously determined we use this model to analyze the comparati

is it inefficient investment that causes the diversification discount diversified conglomerates are valued less than matched portfolios of pure play firms recent studies find that this diversification discount results from conglomerates inefficient allocation of capital expenditures across divisions much of this work uses tobin s q as a proxy for investment opportunities therefore hypothesizing that q is a good proxy this paper treats measurement error in q using a measurement error consistent estimator on the sorts regressions in the literature i find no evidence of inefficient allocation of investment the results in the literature appear to be artifacts of measurement error and of the correlation between investment opportunities and liquidity diversif ied conglomerates appear to trade at a discount relative to matched portfolios of pure play firms studies documenting this stylized fact include lang and stulz 1994 berger and ofek 1995 comment and jarrell 1995 and servaes 1996 recent empirical work has sought to find the source of this diversification discount building on the theoretical work in milgrom and roberts 1990 stein 1997 and scharfstein and stein 2000 on the inefficiency of internal capital markets this literature has asked specifically whether diversified firms allocate their capital expenditures inefficiently across divisions the canonical answer has been yes and has been supported by two types of evidence first studies such as lamont 1997 shin and stulz 1998 shin and park 1998 and rajan servaes and zingales 2000 all find that internal capital markets in conglomerates transfer funds across divisions in a suboptimal manner second studies such as berger and ofek and scharfstein 1998 provide evidence suggesting that the divisions of conglomerates do not respond adequately to investment opportunities in comparison to single segment firms however these findings about divisional investment may be an artifact of measurement error most of these studies rely on tobin s q the market value of the capital stock divided by its replacement value as a proxy for investment opportunities and tobin s q is likely to be a poor proxy shin and stulz

why the npv criterion does not maximize npv this article presents a theory of capital allocation that shows how the use of net present value npv as an investment criterion leads to inefficient capital budgeting outcomes and how this criterion may be dominated by other capital budgeting criteria like the internal rate of return and the profitability index the essence of our theory is rooted in the mainstream paradigm of corporate finance while firms use npv to measure the addition to firm value from prospective projects classical informational and agency considerations prevent it from implementing the optimal capital budgeting outcome our theory also identifies conditions when alternative criteria should be used finally we characterize when direct monitoring through capital budgeting dominates compensation contracts in alleviating the agency problem copyright 2004 oxford university press

matching search and bargaining abstract first the paper incorporates search for alternative opportunities into a model of strategic bargaining second this search and bargaining model is embedded in a market matching model the solutions are presented in a manner that clarifies the role of the search abilities and the details of the bargaining procedure in the determination of the outcomes the predictions of the model are contrasted with the related literature the main accomplishment is the attainment of a manageable model which is still rich enough to grasp important differences between environments which are not captured by the standard matching models

an empirical examination of the sources of changes over time in the job finding rate using reservation wages and rejected wage offers we consider a structural dynamic job search model where nonstationarity originates from the change over time in the benefit level the job offer arrival rate and the wage offer distribution the model is estimated on the french sample of the echp taking advantage of direct observation of reservation wages rejected job offers and associated rejected wages we find that the offered wages deteriorate rapidly 13 8 over six months 19 2 over one year and 30 over two years and that changes in the wage offer distribution are the unique source of negative duration dependence in the hazard

internal capital markets and corporate politics in a banking group we analyze proprietary internal capital allocation data from a large retail banking group consisting of member banks and a headquarters organization we find that capital allocations from headquarters compensate for deposit shortfalls on the bank level suggesting that the headquarters offers deposit smoothing to member banks we then analyze how the distribution of influence within the group relates to capital allocations and lending behavior more influential banks are allocated more funds from headquarters and their loan growth is less sensitive to their deposit base the effects of influence are stronger if banks have a greater demand for deposit smoothing

budget selection when agents compete abstract a principal selects a budget k of how many projects to fund within an organization and then consults n agents each of whom has private information about his own project s value after receiving cheap talk reports from the agents the principal decides which projects to implement subject to the budget and agents report on new i i d projects every period until the budget is exhausted when the budget is small relative to the number of agents each of whom are biased towards their own projects competition between agents degrades the quality of information conveyed in equilibrium and lowers the principal s payoff a larger budget induces less competition and therefore may be selected in order to extract more information from the agents even though this leads to some unprofitable projects being adopted in an extension i find that a policy of never allowing a funded agent to seek funding again increases payoffs compared to when the agent can always re seek funding

reducing household electricity consumption during evening peak demand times evidence from a field experiment abstract peak demand reduction is a key element in demand management programs targeting the stabilization of the electricity grid this study examines a field experiment in austria that investigated rebates and non monetary incentives to reduce household electricity consumption during evening peak demand times the experiment was conducted on 1 257 austrian households using a smart phone application and smart meter data recorded in 15 minutes intervals our results show the strongest behavioral change in households who received the monetary incentive with only weak evidence of changes in the non monetary treatment groups households reduced their consumption in response to the monetary incentive but were then subject to a substantial rebound effect whereby their electricity consumption increased overall

using cost observation to regulate firms the paper emphasizes the use of accounting data in regulatory or procurement contracts when the supplier 1 has superior information about the cost of the project and 2 invests in cost reduction the main result states that under risk neutrality the supplier announces an expected cost and is given an incentive contract linear in cost overruns this optimal contract moves toward a fixed price contract as the announced cost decreases an investment choice is then introduced and the use of a rate of return regulation is studied

moral hazard in corporate investment and the disciplinary role of voluntary capital rationing this paper compares three capital budgeting rules the npv rule a high hurdle rate and capital rationing and explains why some firms may voluntarily impose capital rationing under both capital rationing and a high hurdle a restrictive investment criterion is used to control managerial shirking however implementation of these budgeting rules requires a mechanism to prevent the firm from expanding the investment scale ex post capital rationing in the form of a predetermined fixed budget differs from the high hurdle rate rule in that the former requires the firm to overcome the cost of raising additional capital before making further investment

asymmetric information incentives and intrafirm resource allocation this paper considers the question how should a firm allocate a resource among divisions when the productivity of the resource in each division is known only to the division manager obviously if the divisions as represented by their managers are indifferent among various allocations of the resource the headquarters can simply request the division managers to reveal their private information on productivity knowing that the managers have no incentive to lie the resource allocation problem can then be solved under complete or at least symmetric information this aspect is a flaw in much of the recent literature on this topic i e there is nothing in the models considered which makes divisions prefer one allocation over another thus although in some cases elaborate allocation schemes are proposed and analyzed they are really unnecessary in the model we develop a division can produce the same output with less managerial effort if it is allocated more resources and effort is costly to the manager we further assume that this effort is unobservable by the headquarters so that it cannot infer divisional productivity from data on divisional output and managerial effort given these assumptions we seek an optimal resource allocation process our results show that certain types of transfer pricing schemes are optimal in particular if there are no potentially binding capacity constraints on production of the resource then an optimal process is for each division to choose a transfer price from a schedule announced by the headquarters division managers receive a fixed compensation minus the cost of the resource allocated to them at the chosen transfer price resources are allocated on the basis of the chosen transfer prices if there is a potentially binding constraint on resource production a somewhat more complicated but similar scheme is required

are internal capital markets efficient using segment information from compustat we find that the investment by a segment of a diversified firm depends on the cash flow of the firm s other segments but significantly less than it depends on its own cash flow the investment by segments of highly diversified firms is less sensitive to their cash flow than the investment of comparable single segment firms the sensitivity of a segment s investment to the cash flow of other segments does not depend on whether its investment opportunities are better than those of the firm s other segments

internal versus external capital markets this paper presents a framework for analyzing the costs and benefits of internal versus external capital allocation we focus pritnarily on comparing an internal capital market with bank lending while both represent centralized forms of financing in the former case the financing is owner provided while in the latter ceise it is not we argue that the ownership aspect of internal capital allocation has three important consequences 1 it leads to more monitoring than bank lending 2 it reduces managers entrepreneurial incentives and 3 it makes it easier to efficiently redeploy the assets of projects that are performing poorly under existing management

dominant strategy implementation of bayesian incentive compatible allocation rules abstract a large literature on incentive mechanisms represents incentive constraints by the requirement that truthful reporting be a bayesian equilibrium this paper identifies mechanism design problems for which there is no loss in replacing bayesian incentive compatibility by the stronger requirement of dominant strategies we identify contexts where it is possible to change the transfer payments of an optimal bayesian mechanism so as to create dominant strategies and yet leave every participant s expected utility unchanged we also address the issue of multiple equilibria and unique implementation contexts where these results apply include auctions bilateral bargaining procurement contracting and intrafirm resource allocation

aggregation and linearity in the provision of intertemporal incentives we consider the problem of providing incentives over time for an agent with constant absolute risk aversion the optimal compensation scheme is found to be a linear function of a vector of n accounts which count the number of times that each of the n kinds of observable events occurs the number n is independent of the number of time periods so the accounts may entail substantial aggregation in a continuous time version of the problem the agent controls the drift rate of a vector of accounts that is subject to frequent small random fluctuations the solution is as if the problem were the static one in which the agent controls only the mean of a multivariate normal distribution and the principal is constrained to use a linear compensation rule if the principal can observe only coarser linear aggregates such as revenues costs or profits the optimal compensation scheme is then a linear function of those aggregates the combination of exponential utility normal distributions and linear compensation schemes makes computations and comparative statics easy to do as we illustrate we interpret our linearity results as deriving in part from the richness of the agent s strategy space which makes it possible for the agent to undermine and exploit complicated nonlinear functions of the accounting aggregates

a theory of socialistic internal capital markets abstract we develop a model of a two division firm in which the strong division has on average higher quality investment opportunities than the weak division we show that in the presence of agency and information problems optimal effort incentives are less powerful and thus managerial effort is lower in the strong division this leads the firm to bias its project selection policy against the strong division the selection bias is more severe when there is a larger spread in the average quality of investment opportunities between the two divisions

the capital budgeting process incentives and information we study the capital allocation process within firms observed budgeting processes are explained as a response to decentralized information and incentive problems it is shown that these imperfections can result in underinvestment when capital productivity is high and overinvestment when it is low we also investigate how the budgeting process may be expected to vary with firm or division characteristics such as investment opportunities and the technology for information transfer there is general agreement that investment decisions are the most important decisions made by corporations the choice of projects and the level of investment is critical not just for stakeholders of the firm but also for the economic well being of society as a whole it has been alleged that u s firms invest too little and tend to overemphasize short term results for example porter 1992 citing poterba and summers 1992 asserts that u s firms use hurdle rates to evaluate investment projects that are higher than their estimated costs of capital to understand the investment behavior of firms one must consider both the process by which external capital is made available to firms and the process by which internally and externally raised capital is allocated to investment projects within the firm considerable attention has been paid to how firms raise external capital the fundamental insight in this area is the celebrated result of modigliani and miller mm that capital structure is irrelevant in the absence of capital market frictions accordingly in the three decades since their contribution research on how external capital is raised has focused on market frictions including information and incentive problems relatively little research has focused on the internal allocation process and its relationship to the organization of the firm modern finance theory prescribes allocating capital according to the net present value npv rule just as the mm result itself provides no theory of the arrangements under which

job matching and occupational choice this paper presents a model of job matching the generalizes the existing literature by allowing for different jobs types or occupations such differences affect the value of job specific experience inducing a career profile where certain types are sampled before others more specifically the analysis shows that it is optimal for the young and inexperienced to gravitate toward jobs exhibiting a certain kind of risk then after deriving the equilibrium job turnover rate for an economy in which people do not switch occupations panel data are used to estimate its underlying parameters the hypothesis that people do not switch occupations is rejected against the alternative that they do thus providing empirical support for the theoretical extension undertaken here

managerial incentives and capital management the paper shows how career concerns rather than effort aversion can induce a natural incongruity in risk preferences between managers and superiors a model based on learning about managerial talent is developed to study second best contractual remedies we show that the optimal wage contract is an option of the value of the manager s human capital for insurance reasons and that consequently rationing of capital is often required to counterbalance the manager s resulting incentive to overinvest rationing is strictly superior to price decentralization offering one reason for the prevalence of centralized capital budgeting procedures

capital rationing and organizational slack in capital budgeting this paper reconciles three stylized facts about capital budgeting in firms and shows that they are tied to the presence of asymmetric information among the several members of the firm each with his or her own objectives and decisions the facts of interest are 1 the existence of organizational slack 2 the rationing of resources within organizations 3 the stated cut off rate for accepting capital projects in firms is often greater than the market rate of interest organizational slack is defined as the excess of resources allocated over the minimum necessary to accomplish the tasks assigned resource rationing is defined as the under allocation of resources i e an increase in the amount allocated would generate revenues in excess of its costs rationing and slack are both manifestations of ex post inefficiencies an lp model is used to show that these inefficiencies can occur in ex ante efficient organizational designs when asymmetric information is present the optimal allocation policy involves a hurdle rate criterion in which the hurdle rate is strictly in excess of the cost of capital thus inducing rationing in some states of the world typically resources are optimally allocated such that slack exists in other states the optimal allocation policy trades off these two inefficiencies