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The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment

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  • David S. Scharfstein

    (MIT Sloan School of Management and NBER,)

  • Jeremy C. Stein

    (Harvard University and NBER)

Abstract

We develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division managers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of "socialism" in internal capital allocation, whereby weaker divisions get subsidized by stronger ones. Copyright The American Finance Association 2000.

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Bibliographic Info

Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 55 (2000)
Issue (Month): 6 (December)
Pages: 2537-2564

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Handle: RePEc:bla:jfinan:v:55:y:2000:i:6:p:2537-2564

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  1. Philippe Aghion & Jean Tirole, 1994. "Normal and Real Authority in Organizations," Working papers 94-13, Massachusetts Institute of Technology (MIT), Department of Economics.
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  9. Shleifer, Andrei & Vishny, Robert W., 1989. "Management entrenchment : The case of manager-specific investments," Journal of Financial Economics, Elsevier, vol. 25(1), pages 123-139, November.
  10. Comment, Robert & Jarrell, Gregg A., 1995. "Corporate focus and stock returns," Journal of Financial Economics, Elsevier, vol. 37(1), pages 67-87, January.
  11. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
  12. Berger, Philip G. & Ofek, Eli, 1995. "Diversification's effect on firm value," Journal of Financial Economics, Elsevier, vol. 37(1), pages 39-65, January.
  13. Lamont, Owen, 1997. " Cash Flow and Investment: Evidence from Internal Capital Markets," Journal of Finance, American Finance Association, vol. 52(1), pages 83-109, March.
  14. Meyer, Margaret A & Milgrom, Paul & Roberts, Donald John, 1992. "Organizational Prospects, Influence Costs, and Ownership Changes," CEPR Discussion Papers 665, C.E.P.R. Discussion Papers.
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