Internal Capital Market and Dividend Policies: Evidence from Business Groups

Abstract

This paper argues that the organization of an internal capital market can influence an affiliated firm's dividend policy. The intuition is developed in a model in which business groups -- several independent firms owned and controlled by a family -- operate an internal capital market that uses dividends to lower their cost of external finance: insiders distribute dividends from cash-rich firms and use their share of the payout to finance investments in other affiliated firms. Employing a rich firm-level panel data of business group firms across 22 countries spanning Asia and Europe, we test and find empirical support for this channel. Dividend payments by an affiliated firm are positively correlated with equity financed investments by other firms in its group. This relationship largely accounts for the propensity of affiliated firms to pay more dividends than their unaffiliated counterparts in these countries. A placebo test on 'pseudo' affiliated firms confirms these are not spurious correlations. These results are corroborated by exploiting a quasi-experiment that uses changes in import tariff policy to generate variation in investment opportunities across different industries: a positive shock to the investment opportunity of an affiliated firm is propagated to the dividend policies of unaffected firms in its group.