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Internal Corporate Governance: The Role of Residual Income in Divisional Allocation of Funds

In: International Corporate Governance

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  • Dobrina Georgieva

Abstract

Internal capital markets of diversified firms have been associated with inefficient allocation of investment funds across divisions, leading to value losses. Utilizing a sample of diversified firms that adopted or eliminated Residual Income (RI) plans between 1990 and 2009, we show that adoptions of these plans mitigate investment distortions and lead to value gains. Following the adoption of RI plans, diversified firms start allocating investment funds based on growth opportunities of their divisions. RI plan adopters lower their divisional investment levels, especially in segments with below-average growth opportunities. The overall investment allocation efficiency improves, and the diversification discount diminishes after the adoption of RI plans. However, RI plans appear to be used only as temporary tools for assessing corporate performance. The plans are adopted primarily by firms expected to immediately generate plan bonuses for management, and they are frequently eliminated by firms with bad accounting performance and low managerial bonuses. The study contributes to the literature on organizational efficiency, internal capital markets, and on the importance of measures based on economic profits or RI.

Suggested Citation

  • Dobrina Georgieva, 2015. "Internal Corporate Governance: The Role of Residual Income in Divisional Allocation of Funds," Advances in Financial Economics, in: International Corporate Governance, volume 18, pages 165-206, Emerald Group Publishing Limited.
    • Handle: RePEc:eme:afeczz:s1569-373220150000018006
    DOI: 10.1108/S1569-373220150000018006
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    More about this item

    Keywords

    Internal capital markets; residual income; diversification; investment efficiency; G32; G34;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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