A Note on Euler Allocation for Performance Measurement

It is a well-known result that when an Euler allocation is used to allocate capital by line the overall expected return on capital can be increased by writing more business in lines where the expected return on allocated capital is greater than the overall company wide expected return. If the cost of equity capital varies by line, however, writing more business in these lines may not be the best choice for the company. In this paper we give a simple example that highlights why using an Euler allocation to allocate capital by line for the purpose of performance measurement is not always appropriate if the cost of equity capital varies by line.

Keywords: Capital allocation; Euler allocation; performance measurement; cost of equity capital.