Optimal Design of Internal Capital Markets

Andrey Malenko

No 442, 2011 Meeting Papers from Society for Economic Dynamics

Abstract: This paper studies optimal design of a capital allocation system in a firm in which the division manager with empire-building preferences privately observes the arrival and properties of investment projects, and the headquarters is able to audit each project at a cost. Under certain conditions, the optimal system takes the form of a budgeting mechanism with threshold division of authority. Specifically, the headquarters: (i) allocates a spending account to the manager at the initial date and accumulates it over time; (ii) sets a threshold on the size of individual projects, such that all projects below the threshold are delegated to the manager and financed out of her spending account, while all projects above the threshold are audited and financed fully by the headquarters. The model is extended in several directions, including multiple audit technologies, multiple project categories, and the possibility of renegotiation.

Date: 2011
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