Questions of error

Consider the following two, difficult, questions. How should a financial institution allocate capital to different businesses? How should a financial institution be valued? The first question is a subject for the senior management of an institution. But the way it gets answered leads directly to the second question, whose answer lies in the hands of the institution’s debt and equity investors.

In this month’s first Cutting Edge article, Thomas Wilson looks for a wayof answering the two questions together. According to Wilson, the managers offinancial institutions make a crucial error in allocating capital: they assumethat different business lines have the same cost of capital, which is used toset hurdle rates on projected returns for a given business. The result, he says,is destruction of shareholder value.

The benchmark for analysis of asset returns, the capital asset pricing model