In most multi-divisional firms, divisional managers run their divisions as profit centers: they have broad decision...

In most multi-divisional firms, divisional managers run their divisions as profit centers: they have broad decision rights and are evaluated based on divisional profits.

However, these divisional managers’ decision rights do not typically extend to their capital budget. That is, they are not allowed to choose the amount of capital that they will be allowed to invest in their division as that decision is centralized. These divisional managers have valuable information (specific knowledge) about the appropriate capital expenditures for their division. Why aren’t they allowed to choose their capital budget?

In a recent paper titled Divisional Managers and Internal Capital Markets Professors Ran Duchin and Denis Sosyura of the University of Michigan show that divisional managers with social ties to the CEO receive more capital. Would you expect multi-divisional firms where divisional managers have social ties the CEO to have a smaller or larger diversification discount than multi-divisional firms where the divisional managers do not have social ties to the CEO? Explain.

Solutions

Expert Solution

(a).These divisional managers have more information than the higher level managers about the appropriate capital expenditures for their division. But they are not allowed to take decisions on capital budgeting because of the following reasons -

1). CENTRALISATION OF POWER -

The power of taking decision regarding capital budget is centralized and it us only in the hand of top level manager to take decision about how much finance to be utilized in each division.

2). EXPERIECE OF MAKING BUDGET-

Top level managers have the experience of taking decisions related to budget . This is the work of top level managers that how much money is used in what division and where they are to be consumed.

3). By collecting info about cost -

Top level managers get the details about the expenditure of particular division from divisional managers.

(b). Using hand‐collected data on divisional managers at S&P 500 firms, we study their role in internal capital budgeting. Divisional managers with social connections to the CEO receive more capital. Connections to the CEO outweigh measures of managers' formal influence, such as seniority and board membership, and affect both managerial appointments and capital allocations. The effect of connections on investment efficiency depends on the tradeoff between agency and information asymmetry. Under weak governance, connections reduce investment efficiency and firm value via favoritism. Under high information asymmetry, connections increase investment efficiency and firm value via information transfer.

Rahul Sunny answered 1 year ago

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