Capital Allocation in Financial Firms

Harvard Business School No. 98-072

40 Pages Posted: 25 Apr 2001

See all articles by André Perold

André Perold

Harvard Business School - Finance Unit

Date Written: February 2001


This paper develops a theory of capital allocation in opaque financial intermediaries. The model endogenizes risk management and capital structure decisions, and it provides a simple setting within which to address questions relating to capital budgeting, performance measurement, and employee compensation. It provides a theoretical foundation for understanding the appropriate use, and misuse, of the widely-employed RAROC methodology. The main implications of the model are as follows: a) Projects should be valued by calculating the net present value of cash flows using market-determined discount rates, and subtracting a deadweight cost of capital that is related to the project's marginal contribution to firm-wide risk. b) Diversification across business units reduces the firm's deadweight cost of risk capital. The diversified firm thus faces a larger investment opportunity set and can operate its units on a larger scale than comparable units operated stand-alone. c) Incentive compensation serves an important risk sharing function that results in managerial compensation being less performance-sensitive in units operated within a diversified firm than in units operated stand-alone.

JEL Classification: G21, G22, G31, G32, J33

Suggested Citation

Perold, André F., Capital Allocation in Financial Firms (February 2001). Harvard Business School No. 98-072, Available at SSRN: or

André F. Perold (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6680 (Phone)
617-496-6592 (Fax)

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