Incentives, Capital Budgeting, and Organizational Structure

• Published date: 01 December 2013
• DOI: http://doi.org/10.1111/jems.12033
• Date: 01 December 2013

Incentives, Capital Budgeting, and Organizational

Structure

ADOLFO DE MOTTA

Desautels Faculty of Management

McGill University

Montreal, Quebec, Canada, H3A 1G5

adolfo.demotta@mcgill.ca

JAIME ORTEGA

Department of Business Administration

Universidad Carlos III de Madrid

28903, Getafe (Madrid), Spain

jaime.ortega@uc3m.es

Divisional managers compete for financial resources in what is often referred to as an internal

capital market. They also have a common interest in maximizing corporate profits, as this

determines the resources available to the firm as a whole. Both goals are powerful motivators

but can at times conflict: while the amount of resources available to the firm depends on corporate

performance, divisional funding depends upon the division’s performance relative to the rest. We

propose a model in which organizational form is endogenous, divisions compete for corporate

resources, and managers have implicit incentives. We show that organizational design can help

companies influence their divisional managers’ potentially conflicting goals. Our analysis relates

the firm’s organizational structureto the source of incentives (external vs. internal), the nature of

the incentives (competition vs. cooperation), the level of corporate diversification, the development

of the capital market, and to industry and firm characteristics.

1. Introduction

In large corporations one of headquarters’ main functions, and arguably the most impor-

tant one, is the allocation of resources across differentlines of business—this determines

how corporations grow and evolve over time. Divisional managers compete for re-

sources in what is often referred to as an internal capital market. Yet, managers have

also a common interest in increasing corporate profits so that the firm attains more re-

sources, which can then be channeled to all divisions. Both types of incentives motivate

managers but can sometimes conflict. For example, actively participating in a project

launched by another division can increase corporate profits but may not help one’s po-

sition when competing for internal resources. In fact, engaging in less profitable projects

might be more rewarding from the divisional managers’ perspective if they can more

convincingly claim credit for them. In order to prevent divisions’ particular interests

from harming firm performance, companies need to find ways to channel those interests

We thank the editor, coeditor, and two referees for very helpful comments and suggestions. Adolfo de Motta

gratefully acknowledges funding from the FQRSC program. Jaime Ortega gratefully acknowledges funding

from the Spanish Ministry of Science and Innovation (research grants ECO2009-08278 and ECO2012-33308)

and the Community of Madrid (research grant S2007/HUM-0413).

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 4, Winter 2013, 810–831

Capital Budgeting and Organizational Structure 811

toward corporate goals. This article shows how an appropriate organizational structure

can help.

Weuse a career concerns model (Holmstr ¨

om, 1982) to formalize the dynamic nature

of incentives: investors and corporate headquarters draw inferences from current profits

about the productivities of differentlines of business, which are ex ante unknown, and use

those inferences for capital budgeting. Divisional managers have incentives to influence

this learning process, and hence future investments, by taking costly unobserved actions

that increase profits. In this set up, we study how a multi-product firm fares under

different organizational structures, paying special attention to the most common types

of structure, the so-called unitary and multidivisional forms (U-form and M-form). In

a U-form organization, each divisional manager has responsibilities over all products

or business lines, but her responsibilities are limited to a single function, for example,

marketing or production; whereas in an M-form each divisional manager is responsible

for a single product and controls all functions related to that particular product.

Irrespective of the organizational form, in the model, headquarters are free to

decide how funds are allocated across products, but must allocate functional resources

in fixed proportions. The fixed proportions assumption is made for simplicity, the main

idea being that there is a greater degree of substitutability across products than across

functions. That is, firms can generally do without a particular line of business if it is not

profitable but need to invest in all functional areas for the lines of business in which

they operate.1Empirically,large corporations tend to operate in more than one SIC code,

and, more importantly, they are often involved in acquisitions, alliances, and divestitures

(e.g., 86 Fortune-100 firms were involved in a total of 9,276 acquisitions, alliances, and

divestitures during the 1990s—see Villalonga and McGahan, 2005), which suggests that

reallocations of resources indeed occur primarily across products.

To understand the logic of the model, consider first a U-form organization. Given

that each division manages a number of functions across all products, the internal

allocation of resources by corporate headquarters does not induce competition among

divisional managers.2In these organizations, a division’s funding is mainly determined

by the total amount of funds available for the whole corporation, which depends on

how investors perceive the firm. Divisional managers have incentives to improve this

perception by increasing current profits as this translates into more financing for the

corporation and hence, for their respective divisions.

Incentives work differently in an M-form organization. Because each division is

responsible for one product or line of business, a division’s funding depends not only on

the total funds available for the whole corporation, but also on the share of those funds

that are channeled to each product by corporate headquarters. In this case divisional

managers have incentives to improve both the external perception of the corporation (to

increase total funding) and the internal perception of their divisions (to increase their

own division’s internal funding). More importantly, these two objectives can conflict:

while internal competition for resources provides divisional managers with incentives

1. Even if a firm decides to outsource some functional processes, outsourcing is limited by informational

and hold-up problems (e.g., Grossman and Hart, 1986) and these processes still need to be funded (i.e.,

outsourced goods and services have to be paid for and firms must keep a minimum amount of in-house

resources to ensure proper coordination with suppliers).

2. In general, as long as headquarters’ reallocation of resources across products or business lines is more

important than across functions, a U-form organization will tend to induce less internal competition for

corporate resources than an M-form organization.