DP4169 Optimal Capital Allocation Using RAROC(tm) and EVA

Author(s): Neal Stoughton, Josef Zechner
Publication Date: January 2004
Keyword(s): banking, capital budgeting, financial institutions, investment policy
JEL(s): G20, G21, G30, G31
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4169

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.