Divisional Rent-Seeking, Stock Options and the Quality of Internal Capital Allocation

Abstract

The allocation of resources within a firm is one of the most important decisions made by its management and the allocation of funds is organized in so-called internal capital markets. We empirically investigate to what extent firms’ resource allocation decisions are affected by the CEOs’ response to division-managers’ rent-seeking activities and whether equity incentives throughout the firm, i.e., Employee Stock Option Plans (ESOPs), can mitigate this problem. We argue that the CEO is herself an agent and prefers to use the capital budget as a substitute for increased take-home pay to compensate the division manager for his influence activities. Consistent with this argument, we empirically find that excess capital allocation is negatively associated with division-managers’ take-home pay. We further argue and find that equity incentives throughout the firm alleviate this problem by increasing the quality of internal capital allocation.