Captial Allocation in Financial Firms - Working Paper

This paper develops a theory of capital allocation in opaque financial intermediaries. The model endogenizes risk management and capital structure decisions, and it provides a simple setting within which to address questions relating to capital budgeting, performance measurement, and employee compensation. It provides a theoretical foundation for understanding the appropriate use, and misuse, of the widely-employed RAROC methodology. Key implications of the model are the following: Projects should be valued by calculating the net present value of incremental cash flows using market-determined discount rates, and subtracting a deadweight cost of capital that is related to the project‘s marginal contribution to firm-wide risk. Diversification across business units reduces the firm‘s deadweight costs of capital, and so permits its units to operate on a larger scale than sand-alone. The diversified firm nevertheless can appear to be valued at a "conglomerate discount" because of the non-scalability of the investment opportunity set. Inventive-based compensation serves a risk-sharing function that reduces the firm‘s deadweight costs of capital. This benefit is less pronounced for diversified firms, and since employee risk aversion is a deadweight cost, managerial compensation at the unit level should be less performance-sensitive than in business units operated stand-alone.