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What Do Internal Capital Markets Do? Redistribution vs. Incentives

  • Axel Gautier
  • Florian Heider

In this paper we explain the apparent diversification discount of conglomerates without assuming inefficent-cross subsidisation through internal capital markets. Instead we assume that an internal capital market efficiently redistributes scare resources across a conglomerates divisions between successive production periods. The need for redistribution arises from the fact that resources may sometimes be produced by divisions which happen to be succesful in an earlier production stage but which do not have the best investment opportunities in future production stages. In contrast to the existing literature we consider explicitly the incentive problem between corporate headquarter and divisional managers using a standard Moral-Hazard framework. We show that although a complete incentive contract can be written bi-laterally between headquarter and divisional managers, the redistribution of resources across divisions creates additional agency costs in a conglomerate. Moreover, assuming that no complete contract can govern interim redistribution policy by the headquarter, we show how the agency problem with divisional mangers constrains headquarters interim redistribution to be ex ante inefficient.

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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp386.

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Date of creation: Jul 2001
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Handle: RePEc:fmg:fmgdps:dp386
Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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  1. Oliver Hart & John Moore, 1998. "Default And Renegotiation: A Dynamic Model Of Debt," The Quarterly Journal of Economics, MIT Press, vol. 113(1), pages 1-41, February.
  2. Gertner, Robert H & Scharfstein, David S & Stein, Jeremy C, 1994. "Internal versus External Capital Markets," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 1211-30, November.
  3. Meyer, Margaret A & Milgrom, Paul & Roberts, Donald John, 1992. "Organizational Prospects, Influence Costs, and Ownership Changes," CEPR Discussion Papers 665, C.E.P.R. Discussion Papers.
  4. 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.
  5. Rajan, Raghuram G & Servaes, Henri & Zingales, Luigi, 1998. "The Cost of Diversity: The Diversification Discount and Inefficient Investment," CEPR Discussion Papers 1801, C.E.P.R. Discussion Papers.
  6. 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.
  7. Stein, Jeremy C, 1997. " Internal Capital Markets and the Competition for Corporate Resources," Journal of Finance, American Finance Association, vol. 52(1), pages 111-33, March.
  8. Gordon M Phillips & Vojislav Maksimovic, 1999. "Do Conglomerate Firms Allocate Resources Inefficiently?," Working Papers 99-11, Center for Economic Studies, U.S. Census Bureau.
  9. Emmanuel Saez, 2000. "Optimal Income Transfer Programs: Intensive Versus Extensive Labor Supply Responses," NBER Working Papers 7708, National Bureau of Economic Research, Inc.
  10. Berger, Philip G. & Ofek, Eli, 1995. "Diversification's effect on firm value," Journal of Financial Economics, Elsevier, vol. 37(1), pages 39-65, January.
  11. Milton Harris & Artur Raviv, 1997. "Capital Budgeting and Delegation," CRSP working papers 452, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  12. Lamont, Owen, 1997. " Cash Flow and Investment: Evidence from Internal Capital Markets," Journal of Finance, American Finance Association, vol. 52(1), pages 83-109, March.
  13. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
  14. Jeremy C. Stein, 2000. "Information Production and Capital Allocation: Decentralized vs. Hierarchical Firms," NBER Working Papers 7705, National Bureau of Economic Research, Inc.
  15. David S. Scharfstein, 1998. "The Dark Side of Internal Capital Markets II: Evidence from Diversified Conglomerates," NBER Working Papers 6352, National Bureau of Economic Research, Inc.
  16. Comment, Robert & Jarrell, Gregg A., 1995. "Corporate focus and stock returns," Journal of Financial Economics, Elsevier, vol. 37(1), pages 67-87, January.
  17. Hyun-Han Shin & René M. Stulz, 1998. "Are Internal Capital Markets Efficient?," The Quarterly Journal of Economics, MIT Press, vol. 113(2), pages 531-552, May.
  18. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
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