Discussion Paper Details

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Title: Optimal Capital Allocation Using RAROC(tm) and EVA

Author(s): Neal Stoughton and Josef Zechner

Publication Date: January 2004

Keyword(s): banking, capital budgeting, financial institutions and investment policy

Programme Area(s): Financial Economics

Abstract: This Paper analyses firms? capital allocation decisions when optimal capital structure is linked to the risk of underlying assets and when equity capital is costly and cannot be raised instantaneously. In the model, division managers receive private information and authority is delegated to them over risky project choices. The optimal mechanisms are related to EVA compensation and RAROC performance measurement systems. In the optimal mechanism, position limits will be employed but are not always completely utilized. Hurdle rates reflect capital allocation through a division-specific capital structure. In the multidivisional context the optimal capital allocation mechanism incorporates valuable externalities leading to overall firm EVA maximization.

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Bibliographic Reference

Stoughton, N and Zechner, J. 2004. 'Optimal Capital Allocation Using RAROC(tm) and EVA'. London, Centre for Economic Policy Research.