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Reallocation of Corporate Resources and Managerial Incentives in Internal Capital Markets

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  • Brusco, Sandro
  • Panunzi, Fausto

Abstract

One distinguishing feature of internal capital markets is their ability to reallocate funds in favour of the most profitable divisions (winner-picking). Yet, diversified firms often trade at a discount with respect to their focused counterparts. The literature has tried to explain the apparent misallocation of resources with lobbying activities or power struggles. We show that the diversification discount can be explained even in a model where resources are efficiently allocated ex post. When managers obtain utility from the funds under their purview, moving funds across divisions may diminish their incentives. The ex ante reduction in managerial incentives can more than offset the increase in firm value due to the ex post efficient reallocation of funds. If headquarters have some commitment power, it is in general optimal to commit not to reallocate at least a fraction of funds. As a result, the investment in a given division is (optimally) more sensitive to the division's cash flow than to other divisions' cash flow, as confirmed by the empirical studies on internal capital markets. Our theory complements the view that links the diversification discount to the inefficient functioning of internal capital markets.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2532.

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Date of creation: Sep 2000
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Handle: RePEc:cpr:ceprdp:2532

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Keywords: Internal Capital Markets; Managerial Incentives; Winner-Picking;

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References

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  1. David S. Scharfstein & Jeremy C. Stein, 2000. "The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment," Journal of Finance, American Finance Association, vol. 55(6), pages 2537-2564, December.
  2. Stein, Jeremy C., 2003. "Agency, information and corporate investment," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 2, pages 111-165 Elsevier.
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  14. José Manuel Campa & Simi Kedia, 1999. "Explaining the Diversification Discount," Working Papers 99-06, New York University, Leonard N. Stern School of Business, Department of Economics.
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  16. Toni M. Whited, 2001. "Is It Inefficient Investment that Causes the Diversification Discount?," Journal of Finance, American Finance Association, vol. 56(5), pages 1667-1691, October.
  17. Brusco, Sandro & Panunzi, Fausto, 2005. "Reallocation of corporate resources and managerial incentives in internal capital markets," European Economic Review, Elsevier, vol. 49(3), pages 659-681, April.
  18. Gordon M Phillips & Vojislav Maksimovic, 1999. "Do Conglomerate Firms Allocate Resources Inefficiently?," Working Papers 99-11, Center for Economic Studies, U.S. Census Bureau.
  19. Fluck, Zsuzsanna & Lynch, Anthony W, 1999. "Why Do Firms Merge and Then Divest? A Theory of Financial Synergy," The Journal of Business, University of Chicago Press, vol. 72(3), pages 319-46, July.
  20. Jeremy C. Stein, 2000. "Information Production and Capital Allocation: Decentralized vs. Hierarchical Firms," NBER Working Papers 7705, National Bureau of Economic Research, Inc.
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