Daily Link Orgy - July 9, 2009

The Social Science Research Network is an excellent source of academic papers regarding many different topics. Don't be misled by the Social Science name, as the site has many financial and investing related papers.

Over the next week or so, I will post a list of the top ten downloaded financial or investing related papers. Some of them are classics and some may be a little surprising. Most of them are free to download as well.

This is the tenth most downloaded paper related to a financial or investing topic.

Optimal Capital Allocation Using RAROC and EVA - By Neal Stoughton and Josef Zechner - Downloaded 21,718 times.

Abstract

"Equity capital allocation plays a particularly important role for financial institutions such as banks, who issue equity infrequently but have continuous access to debt capital. In such a context this paper shows that EVA and RAROC based capital budgeting mechanisms have economic foundations. We derive optimal capital allocation under asymmetric information and in the presence of outside managerial opportunities for an institution with a risky and a riskless division. It is shown that the results extend in a consistent manner to the multidivisional case of decentralized investment decisions with a suitable redefinition of economic capital. The decentralization leads to a charge for economic capital based on the division's own realized risk. Outside managerial opportunities increase the usage of capital and lead to overinvestment in risky projects; at the same time more capital is raised but risk limits are binding in more states. An institution with a single risky division should base its hurdle rate for capital allocated on the cost of debt. In contrast, the hurdle rate tends to the cost of equity for a diversified multidivisional firm. The analysis shows that hurdle rates have a common component in contrast to the standard perfect markets result with division-specific hurdle rates."

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