Discussion Paper Details

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Title: Reallocation of Corporate Resources and Managerial Incentives in Internal Capital Markets

Author(s): Sandro Brusco and Fausto Panunzi

Publication Date: September 2000

Keyword(s): Internal Capital Markets, Managerial Incentives and Winner-Picking

Programme Area(s): Financial Economics

Abstract: One distinguishing feature of internal capital markets is their ability to reallocate funds in favour of the most profitable divisions (winner-picking). Yet, diversified firms often trade at a discount with respect to their focused counterparts. The literature has tried to explain the apparent misallocation of resources with lobbying activities or power struggles. We show that the diversification discount can be explained even in a model where resources are efficiently allocated ex post. When managers obtain utility from the funds under their purview, moving funds across divisions may diminish their incentives. The ex ante reduction in managerial incentives can more than offset the increase in firm value due to the ex post efficient reallocation of funds. If headquarters have some commitment power, it is in general optimal to commit not to reallocate at least a fraction of funds. As a result, the investment in a given division is (optimally) more sensitive to the division's cash flow than to other divisions' cash flow, as confirmed by the empirical studies on internal capital markets. Our theory complements the view that links the diversification discount to the inefficient functioning of internal capital markets.

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Bibliographic Reference

Brusco, S and Panunzi, F. 2000. 'Reallocation of Corporate Resources and Managerial Incentives in Internal Capital Markets'. London, Centre for Economic Policy Research.