Firm Vertical Boundaries, Internal Capital Markets, and Firm Performance

Abstract

In this paper, we investigate how vertical relatedness between business segments affects capital allocation within internal capital markets. Using a battery of tests including exogenous reductions in import tariff rates, we show that investments tend to flow towards segments with better investment opportunities in firms with significant vertical relatedness between business segments. We also link internal capital allocations to operating performance by showing that the efficiency of internal capital allocations predicted by vertical integration is a significant determinant of firm productivity and operating profitability. Overall, we show that the corporate headquarters efficiently allocates resources across divisions in vertically integrated firms and that this superior capital allocation is one channel through which vertical integration impacts real outcomes of firms.