Decentralized Capital Budgeting Decisions and Shareholder Wealth Maximization

By Robert H. LitzenbergerO. Maurice Joy
1973| Working Paper No. 163

The firm’s objective function is well defined as shareholder wealth maximization. However, the firm is a group of individuals and each member has objectives that are not necessarily coincidental to the organization’s goal. This paper investigates the organizational control problem of how to insure that small decentralized capital budgeting decisions are consonant with shareholder wealth maximization. Descriptively, many firms specify operating rules for subordinate managers in terms of target rates of return on investment. An apparent conflict exists between the corporate objective of shareholder wealth maximization and the disparate decentralized decision making objectives induced by enforcement rules based upon the ex post realization of a pre-specified target rate of return on investment. However, properly specified target rates of return are shown to induce decentralized investment decisions that are consistent with shareholder wealth maximization. A corporation’s specification of operating rules in terms of target rates of return on investment should be construed as prima facie evidence of satisficing behavior.