Corporate capital allocation: a behavioral perspective

Previous research on capital investment has identified a tendency in multi-business firms toward cross-subsidization from well performing to poorly performing divisions, a phenomenon that has previously been attributed to principal-agent conflicts between headquarters and divisions (Stein, 2003). In this paper we argue that cross-subsidization reflects a more general tendency toward even allocation over all divisions in multi-business firms that is driven at least in part by the cognitive tendency to naïvely diversify when making investment decisions (Benartzi and Thaler, 2001). We observe that this tendency also leads to partition dependence in which capital allocations vary systematically with the divisions and subdivisions into which the firm is organized or over which capital is allocated. Our first study uses archival data to show that firms’ internal capital allocations are biased toward equality over the number of business units into which the firm is partitioned. Two further experimental studies of experienced managers examine whether this bias persists when participants are asked to allocate capital to various divisions of a hypothetical firm. This methodology eliminates the possibility of agency conflicts. Nevertheless, allocations varied systematically with the divisional and subdivisional structure of the firm, and whether capital was allocated in a centralized or decentralized manner