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Influence and inefficiency in the internal capital market

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  • Wulf, Julie
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    Abstract

    I model inefficient resource allocations in M-form organizations due to influence activities by division managers that skew capital budgets in their favor. Corporate headquarters receives two types of signals about investment opportunities: private signals that can be distorted by managers, and public signals that are undistorted but noisy. Headquarters faces a tradeoff between the cost of attaining an accurate private signal and the value of the information the signal provides. In contrast to existing models of "socialism" in internal capital markets, I show that investment sensitivity to Tobin's Q is higher than first-best in firms where division managers hold equity (a result consistent with evidence presented in Scharfstein, 1998). When managers face high private costs from distorting information (equity holdings), headquarters may commit to investment contracts that place "too little" weight on private signals and "too much" weight on public signals (i.e. Q). This result has implications for managers in the design of capital budgeting processes and incentive compensation systems.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Economic Behavior & Organization.

    Volume (Year): 72 (2009)
    Issue (Month): 1 (October)
    Pages: 305-321

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    Handle: RePEc:eee:jeborg:v:72:y:2009:i:1:p:305-321

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    Web page: http://www.elsevier.com/locate/jebo

    Related research

    Keywords: Firm investment M-form organization Internal capital markets Asymmetric information Signal-jamming Influence activities;

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    Cited by:
    1. Löffler, Clemens & Pfeiffer, Thomas, 2013. "Centralized versus Decentralized External Financing, Winner Picking and Corporate Socialism," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79902, Verein für Socialpolitik / German Economic Association.
    2. Glaser, Markus & Lopez-de-Silanes, Florencio & Sautner, Zacharias, 2010. "Opening the Black Box: Internal Capital Markets and Managerial Power," MPRA Paper 28488, University Library of Munich, Germany.
    3. Stefan Erdorf & Thomas Hartmann-Wendels & Nicolas Heinrichs & Michael Matz, 2013. "Corporate diversification and firm value: a survey of recent literature," Financial Markets and Portfolio Management, Springer, vol. 27(2), pages 187-215, June.
    4. Seru, Amit, 2014. "Firm boundaries matter: Evidence from conglomerates and R&D activity," Journal of Financial Economics, Elsevier, vol. 111(2), pages 381-405.
    5. Bradford, William & Chen, Chao & Zhu, Song, 2013. "Cash dividend policy, corporate pyramids, and ownership structure: Evidence from China," International Review of Economics & Finance, Elsevier, vol. 27(C), pages 445-464.
    6. Vinod Mishra & Rajabrata Banerjee & Tania Dey, 2011. "Influence Activity And Allocation Of Firms' Internal Capital: Evidence From Australia," Development Research Unit Working Paper Series 38-11, Monash University, Department of Economics.
    7. Kolasinski, Adam C., 2009. "Subsidiary debt, capital structure and internal capital markets," Journal of Financial Economics, Elsevier, vol. 94(2), pages 327-343, November.
    8. Cremers, M. & Huang, R. & Sautner, Z., 2009. "Understanding Internal Capital Markets and Corporate Policies," Discussion Paper 2009-47 S, Tilburg University, Center for Economic Research.

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