Capital Budgeting: The Role of Cost Allocations

A common issue for firms is how to allocate capital resources to various investment alternatives. An extensive and long-standing 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. 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. There has been significant progress in recent years in understanding the role of intertemporal cost charges, specifically depreciation and capital charges, in the capital budgeting process. Cost allocations across time periods and business units are essential in creating time-consistent performance measures that compare initial reports to subsequently realized outcomes. But major challenges remain in making the existing models more complete on several fronts, including (i) richer settings of capacity investments and subsequent capacity utilization, (ii) projects with sequential decisions stages and (iii) the coordination of risk exposures across the divisions of a firm. This paper reviews extant research and suggests avenues for further research.