Dynamic project selection

Corporate finance textbooks (e.g., Webster 2003, Chapter 12) recommend that a company invest in a project if and only if the project’s internal rate of return exceeds the cost of capital. If companies operated this way, their investment decisions would be independent across projects within the company, conditional on the projects’ cash flows being independent. In practice, such conditional independence is the exception rather than the rule (Ozbas and Scharfstein 2010). Investment decisions on projects with independent cash flows can be dependent for two reasons: projects may be mutually exclusive or the internal capital used to finance these projects may be scarce. We use the term “internal capital market” to describe a project-selection mechanism that deals with either situation. We are interested in the design of an optimal internal capital market for environments with independent cash flows. We focus on the problem in which project values are initially unknown but can be learned over time. Before deciding which project to finance, a company performs due diligence on each project. The Universal Music Group faced such a situation in 2011. Universal was considering two alternative projects: the purchase of EMI Music or the purchase of Warner Music Group.1 Purchasing both was infeasible, if only because of