Corporations use a variety of processes to allocate capital. This article studies the benefits and costs of several common budget procedures from the perspective of a model with agency and information problems. Processes that delegate aspects of the decision to the agent result in too many projects being approved, while processes in which the principal retains the right to reject projects cause the agent to strategically distort his information about project quality. We show how the choice of a decision process depends on these two costs, and specifically on severity of the agency problem, quality of information, and project risk.Capital budgeting would be easy in a world without agency and information problems. The decision-maker would simply calculate a project's IRR and compare it to the cost of capital. But in the real world, those providing the funds for investment must rely on self-interested agents to identify projects and provide information on expected returns. As a result, the quality of capital allocation depends on how effective the decision process is in attenuating agency problems and bringing forth accurate information. Corporations employ a variety of decision procedures in practice: Some decisions are fully delegated to division and plant managers (typically, expansion of an existing plant); some decisions require approval of headquarters (typically, construction of a new plant); and other decisions require approval conditional on the nature of the proposal, such as when projects requiring more than $1 million go to headquarters while smaller projects can be approved locally.
1The main purpose of this article is to shed some light on the tradeoffs between several commonly used budget procedures. To this end, weWe thank Thomas Gilligan, Li Hao, Randall Kroszner, Krishna Kumar, Fulvio Ortu, Jaffer Qamar, Eric Rasmusen, Eric Talley, and Jan Zabojnik for helpful discussions. We would also like to acknowledge constructive feedback from workshop participants at
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