Capital Budgeting and Managerial Retention under Product Market Competition

Abstract

This paper studies how division managers' access to venture capital (VC) markets affects the internal capital allocation decision of a multi-division firm. Division managers may leave firms and seek venture financing if their project ideas are not funded by headquarters. A successful new venture poses a threat to the revenue of the incumbent firm through product market competition. The paper characterizes headquarters' decision to retain managers and allocate capital for different degrees of product market competition and fundamental parameters in the VC markets. The paper shows that distortions in internal capital allocations arise as headquarters retains managers by allocating more capital to their divisions and increasing compensation. These distortions may lead to under-investment or over-investment in high NPV projects as well as creation of new ventures. The paper also shows that improving efficiency in the VC markets may induce incumbent firms to aggressively retain managers by over-investing in their ideas and may not necessarily lead to more VC-backed startups. The incentive to retain managers is higher in more concentrated industries. The paper derives novel empirical implications linking industry characteristics to diversification benefits and investment behavior of multidivisional firms.