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

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.