15. internal cost of funds and rationing23 Ralph manages a decentralized firm where division managers have significant authority to make production and investment decisions.

All capital expenditures must be approved by center. Divisions must submit detailed capital budgets prior to approval by center. This is one area where Ralph is somewhat disappointed with decentralization, as divisions show a marked tendency to pad their budgets.

Slack in the budgets makes life more pleasant at the divisions. If a division’s budget is successfully padded, division personnel have an easier time meeting the budget. Think of this as the division personnel consuming the slack in the budget. That said, Ralph is aware one of the divisions has a capital project that will yield a cash flow of 100 at the end of one year. Ralph believes this project will cost 75 or 65, with equal probability. The division, though, knows with certainty what the cost will be. This leads to a concern the division might pad its budget on this project. To prevent this, a project auditing program, which will discover the actual project cost and report directly to center, is being considered. How much would Ralph be willing to pay for the project auditing of this capital project? Ralph’s opportunity cost of capital is 20%, and Ralph is risk neutral. For simplicity, assume the budget is submitted and funds are provided to division at the beginning of the year. The benefits of the project (100) will be available to Ralph at the end of the year.