Capital Rationing and Organizational Slack in Capital Budgeting
Article Abstract:
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 necssary to accomplish the tasks assigned. Resource rationing is defined as the underallocation 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. (Reprinted by Permission of Publisher.)
Publication Name: Management Science
Subject: Business, general
ISSN: 0025-1909
Year: 1985
User Contributions:
Comment about this article or add new information about this topic:
Project evaluation and control in decentralized firms: is capital rationing always optimal?
Article Abstract:
Business organizations often employ decision rules similar to capital rationing when they make capital investment decisions. However, it has been observed that the opposite of capital rationing, a list of 'must do' projects, also exists in many firms. Results of extant studies indicate that these 'must do' projects represent a leniency in the capital budgeting system since they are not as strictly evaluated and scrutinized like other projects. This creates a paradox in that 'must do' projects enjoy a preferential screening while other projects continue to be subjected to the usual treatment that resembles capital rationing. To gain a better understanding of this issue, a principal-agent model is analyzed that is risk-neutral and has two productive inputs: the agents' efforts and capital investment.
Publication Name: Management Science
Subject: Business, general
ISSN: 0025-1909
Year: 1995
User Contributions:
Comment about this article or add new information about this topic:
Moral hazard in corporate investment and the disciplinary role of voluntary capital rationing
Article Abstract:
Three capital-budgeting rules are compared, namely, the Net Present Value rule, capital rationing and a high hurdle rate. Capital budget is explicitly linked to managerial incentives and serves as a strategic tool to control managerial shirking. Analysis indicates that the source of financing has different effects on managerial incentives and firm profit. It also shows that firm investment may not be monotonically linked to the amount of internal capital available for funding the investment. The possibility of firms engaging in additional financing in some of the states subsequent to the initial budget explains why some firms choose a sequential financing policy in funding projects, even when a fixed cost exists each time in financing.
Publication Name: Management Science
Subject: Business, general
ISSN: 0025-1909
Year: 1997
User Contributions:
Comment about this article or add new information about this topic:
- Abstracts: How Non-U.S. MNCs Practice Capital Budgeting. Abandonment Value in Capital Budgeting: Another View. Dangers in Discounting
- Abstracts: Organizational environments and the multinational enterprise
- Abstracts: Investment planning and arm's length control in a nationalised industry. Large scale portfolio optimization
- Abstracts: Issues in understanding and changing corporate culture. Managing culture: the invisible barrier to strategic change
- Abstracts: Interstate banking and small business finance: implications from available evidence. Can your small company acquire resources as favorably as the large company?