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Financial constraints and investment efficiency: Internal capital allocation across the business cycle

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  • Hovakimian, Gayané
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    Abstract

    The extent to which conglomerates face frictions in external capital markets has implications for their internal capital allocation. We find that, during recessions, when external financing costs are higher, conglomerates improve the efficiency of internal capital markets by increasing the allocation of funds to high q divisions relative to low q divisions. The improvement is significantly higher for conglomerates that are likely to face more binding financial constraints. This evidence suggests that although financial constraints impair managers' ability to undertake positive net present value projects, they improve the quality of project selection by reducing free cash flow and pressuring managers to fund the more valuable investment opportunities. It is consistent with theories stressing the benefits of internal capital markets in the presence of external capital market imperfections.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Intermediation.

    Volume (Year): 20 (2011)
    Issue (Month): 2 (April)
    Pages: 264-283

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    Handle: RePEc:eee:jfinin:v:20:y:2011:i:2:p:264-283

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    Web page: http://www.elsevier.com/locate/inca/622875

    Related research

    Keywords: Internal capital market Conglomerate Financial constraint Internal capital allocation Diversification;

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    Cited by:
    1. Cline, Brandon N. & Garner, Jacqueline L. & Yore, Adam S., 2014. "Exploitation of the internal capital market and the avoidance of outside monitoring," Journal of Corporate Finance, Elsevier, vol. 25(C), pages 234-250.
    2. 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.
    3. Gregor Matvos & Amit Seru, 2011. "Resource Allocation within Firms and Financial Market Dislocation: Evidence from Diversified Conglomerates," NBER Working Papers 17717, National Bureau of Economic Research, Inc.

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