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This paper develops a theory of resource allocation in internal capital markets that is consistent with the empirical finding that multi-division firms bias their investment levels in favor of divisions with weaker investment prospects. We characterize an internal capital market as an informed principal-agent relationship in which headquarters with control rights over internal funds has private information about the relative quality of future investment opportunities of its divisions. Then capital allocation may serve as a signal to divisional managers. Headquarters' optimal policy involves strategic distortions in favor of divisions with poorer investment opportunities.
Abstract
Informed Headquarters and Capital Allocation in Multi-Divisional Firms
Hoang, Daniel; Ruckes, MartinThis paper develops a theory of resource allocation in internal capital markets that is consistent with the empirical finding that multi-division firms bias their investment levels in favor of divisions with weaker investment prospects. We characterize an internal capital market as an informed principal-agent relationship in which headquarters with control rights over internal funds has private information about the relative quality of future investment opportunities of its divisions. Then capital allocation may serve as a signal to divisional managers. Headquarters' optimal policy involves strategic distortions in favor of divisions with poorer investment opportunities.