Promotion Tournaments and Capital Rationing

We analyze capital allocation in a conglomerate where divisional managers with uncertain abilities compete for promotion to CEO. A manager can sometimes gain by unobservably adding variance to divisional output. Capital rationing can limit this distortion, increase productive efficiency, and allow the owner to make more accurate promotion decisions. Firms in which the CEO has a greater span of control are more likely to use capital rationing. A rationed manager is more likely to be promoted even though all managers are identical ex ante. Overconfidence can increase a manager’s likelihood of promotion and can even benefit the (fully rational) owner.