On the Decentralized Capital Budgeting Problem under Uncertainty

This paper deals with decentralized capital budgeting problems when decision objectives are not necessarily identical with those of corporate headquarters.

This paper extends previous analysis of this problem to the case where (i) the cash flows resulting from managerial actions are uncertain, (ii) division managers have nonlinear utility functions which differ from those of top management with respect to risk aversion and (iii) resource constraints may be nonlinear. Several realistic considerations arise in this context which were absent in previous analyses. First, because the division managers' utility functions reflect differing attitudes toward risk, top management has the opportunity to share some business risk with the division managers. We recommend a transfer pricing scheme that accounts for this possibility. Second, if the transfer prices for capital resources are state-dependent and the division managers make their investment decisions before the state of nature is revealed, the division managers will want to hedge against the additional uncertainty caused by this aspect of the problem. Despite the static nature of the analysis this paper raises the interesting problem of information flow within the firm and suggests ways to motivate division managers to act in the best interest of the firm. The transfer pricing algorithm has additional interesting applications.