Incentives, Capital Budgeting, and Organizational Structure

Divisional managers compete for financial resources in what is often referred to as an internal capital market. They also have a common interest in maximizing corporate profits, as this determines the resources available to the firm as a whole. Both goals are powerful motivators but can at times conflict: while the amount of resources available to the firm depends on corporate performance, divisional funding depends upon the division's performance relative to the rest. We propose a model in which organizational form is endogenous, divisions compete for corporate resources, and managers have implicit incentives. We show that organizational design can help companies influence their divisional managers' potentially conflicting goals. Our analysis relates the firm's organizational structure to the source of incentives (external vs. internal), the nature of the incentives (competition vs. cooperation), the level of corporate diversification, the development of the capital market, and to industry and firm characteristics.