Allocating capital among a firm's divisions: hurdle rates vs. budgets

This paper examines the merits of alternative systems for allocating capital within a firm. A budget system, whereby top management limits divisional investment, even without full knowledge of the divisions' investment opportunities, can make economic sense. The budget system can be useful when there are externalities among the investments of different divisions and when division managers' estimates of projects' NPVs are subject to unpredictable errors. The budget system is weak, however, in terms of its use of division managers' expertise. As a result, most firms use budgets as only one part of their capital allocation system.