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Capital Budgeting: The Role of Cost Allocations

In: Operations Research Proceedings 2006

Author

Listed:
  • Ian Gow

    (Stanford University)

  • Stefan Reichelstein

    (Stanford University)

Abstract

A common issue for firms is how to allocate capital resources to various investment alternatives. An extensive literature in finance has examined various aspects of capital budgeting, including capital constraints, the determination of discount rates, and alternative approaches to estimating cash flows and handling risk, such as real options techniques. In terms of organizational structure, a central feature of the capital budgeting process in large firms is that relevant information about the profitability of potential investment projects resides with one or several managers. It is generally accepted that preferences of these managers may not coincide with those of the firm’s owners (the principal). Consequences of asymmetric information include strategic reporting by better-informed managers (for example, “sandbagging” or “creative optimism”) and a need to measure performance ex post. Surveys consistently find that internal rate of return (IRR) criteria remain prevalent in capital budgeting decisions. Furthermore the use of artificially high hurdle rates suggests widespread capital rationing [15, 20].

Suggested Citation

  • Ian Gow & Stefan Reichelstein, 2007. "Capital Budgeting: The Role of Cost Allocations," Operations Research Proceedings, in: Karl-Heinz Waldmann & Ulrike M. Stocker (ed.), Operations Research Proceedings 2006, pages 115-121, Springer.
    • Handle: RePEc:spr:oprchp:978-3-540-69995-8_19
    DOI: 10.1007/978-3-540-69995-8_19
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    Cited by:

    1. Feng, Felix Zhiyu & Westerfield, Mark M., 2021. "Dynamic resource allocation with hidden volatility," Journal of Financial Economics, Elsevier, vol. 140(2), pages 560-581.
    2. Magni, Carlo Alberto & Marchioni, Andrea, 2020. "Average rates of return, working capital, and NPV-consistency in project appraisal: A sensitivity analysis approach," International Journal of Production Economics, Elsevier, vol. 229(C).

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