There is widespread agreement that investment decisions are the most important decisions made by firms. In fact, most large firms pay considerable attention to designing capital budgeting systems, and do so in a manner suggesting that firms recognize incentive problems in the internal allocation of capital across organizational units. For example, firms use hurdle rates that are higher than their cost of capital, possibly as a crude measure of addressing managerial attempts to overstate cash flow projections (Poterba & Summers, 1995). In addition, there is a popular trend toward ‘charging’ divisions for the cost of capital by using economic value added (EVA) as a performance measure in determining executive pay (Ittner & Larcker, 1998). Finally, capital rationing is a common practice (Taggart, 1987) and theories suggest that it is used partially to address decentralized information and incentive problems (Harris & Raviv, 1996; Holmstrom & Ricart i Costa, 1986). The purpose of the paper is to explore the use of various instruments by multi-divisional firms as a means to control information and incentive problems in the allocation of capital across divisions.
