An Information Economizing Approach to Capital Budgeting in Firms with Internal Capital Markets

Andrew B. Carver

The College of New Jersey

Abstract

Capital budgeters in large firms must match the supply of available funds to demand from worthy projects. Because detailed information about project values lies at the project group level, a centralized decision maker can find it difficult to determine the optimal budget size since different budget sizes have varying capital costs and hence changing individual project values. This paper introduces an information economizing capital budgeting procedure that allows decision makers to use duration information imbedded in the internal rate of return (IRR) to estimate the value of projects using a number of different discount rates. The sensitivity information is incorporated into an iterative procedure that allows a capital budgeter to start with an estimated budget size and converge to an optimal budget size. This procedure offers practical advantages over the traditional alternative of setting up an optimization problem or using Macaulay duration to adjust project values.

Key Words: Capital Budgeting, Duration, IRR, Internal Capital Markets