The Economics of Capital Allocation in Firms: Evidence from Internal Capital Markets

We analyze a unique chief financial officer (CFO) survey data set to examine capital allocation in firms. Top management is aware of agency and information problems at the divisional level and organizes the budgeting process to counteract managerial opportunism, employing systems of interconnected measures, including layers of approval, divisional budgets, reporting requirements, and compensation schemes. When making funding decisions, top management relies heavily on top-level nonfinancial information, such as the assessment of divisional managers’ abilities. However, substantial parts of the capital budget do not require top management approval as firms trade off the benefits and costs of decentralization, thereby deviating from the traditional paradigm of decentralized project initiation but centralized project approval. Even firms with active internal capital markets tilt capital allocation toward relatively even distributions, reflecting the use of capital allocation as a credible communication device. We also find that within-firm agency problems may result in capital rationing, that is, divisions’ restricted access to internal capital. CFOs also believe that integrating multiple businesses into an internal capital market results in tangible financial benefits, predominantly lower costs of capital and higher debt capacities. Thus, our findings also support coinsurance arguments suggesting that internal capital markets may improve access to external financing.