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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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    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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    File URL: http://www.sciencedirect.com/science/article/pii/S1042-9573(10)00036-7
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    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
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622875

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