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Business Analytics

What Can Headquarters Do If Divisions Prefer Capital-Intensive Projects?

Dr Erick Li, Discipline of Business Analytics The University of Sydney

19th Oct 2012  11:00 am - Room 498 Merewether Building H04

We analyse the friction between the headquarters and the divisional manager in the project selection process. The divisional manager who prefers capital-intensive projects manipulates the selection process by presenting the project that maximizes the managerial utility rather than the added value. Because the headquarters cannot observe all available projects, an ex ante standard for project approval must be specified. We derive the optimal standard for the headquarters. The optimal standard can be described by a threshold function that has a complex form. We also study several heuristics that are commonly used in practice. Our analysis indicates that the heuristic that imposes a hurdle rate on the project return rate gives the headquarters almost the same payoff as the optimal standard does. However, the headquarters¿¿¿ payoff reduces substantially if a threshold is put on the required capital or the expected return. Our findings underscore the importance of using appropriate criterion in project selection process to mitigate the organizational challenge caused by misaligned objectives and information asymmetry. Although NPV is the best statistics to measure added values, it is not the best instrument to increase the added values.