Capital Budgeting in the Decentralized Firm

Abstract

In this paper we analyze the capital budgeting problem of an organization which contains a central headquarters and K divisions. The headquarters serves as the planner-coordinator of the capital budgeting process and is the only member of the organization which has access to the external capital markets. The K divisions make decisions regarding the set of capital projects each wants to accept. The capital budgeting problem of this decentralized organization is solved and analyzed with the aid of an algorithm based on mathematical decomposition. It is shown that (i) the decomposition algorithm does indeed converge to an optimal corporate solution, (ii) under reasonable assumptions, the marginal rate of return on the last dollar spent is the same for each division and is equal to the corporate headquarters' “cost of capital,” (iii) in some circumstances, the decomposition model will only select integral projects, and (iv) the optimal choice of projects for the firm is made independently by the divisions, each acting in its own self-interest. This last feature of the capital budgeting model suggests that the firm may be able to achieve the informational economies usually associated with a decentralized organization structure.

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