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Title: A q Theory of Internal Capital Markets

Author(s): Min Dai, Xavier Giroud, Wei Jiang and Neng Wang

Publication Date: October 2020

Keyword(s):

Programme Area(s): Financial Economics

Abstract: We propose a tractable model of dynamic investment, division sales (spinoffs), financing, and risk management for a multi-division firm that faces costly external finance. The model highlights the importance of considering the intertwined nature of the different policies. Our main results are as follows: (1) risk management considerations prescribe the allocation of resources based not only on the divisions' productivity -- as in standard models of ''winner picking'' -- but also their risk; (2) firms may choose to voluntarily spin off productive divisions to increase liquidity; (3) diversification can reduce firm value especially in low liquidity states, as it increases the cost of a spinoff and hampers liquidity management; (4) with corporate socialism, liquidity is less valuable since it is less costly to replenish the firm's liquidity through a spinoff; and (5) division-level investment is set such that the ratio between marginal q and the marginal cost of investing in each division equals the marginal value of cash.

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Bibliographic Reference

Dai, M, Giroud, X, Jiang, W and Wang, N. 2020. 'A q Theory of Internal Capital Markets'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=15341