Resource Allocation in Conglomerates under Moral Hazard

Abstract

This paper investigates the resource allocation decision in conglomerates under moral hazard. We consider a firm where the input factors are unknown managerial ability that is common to all divisions, capital allocated to each division, and intangible resources that the manager allocates to each division. While capital allocation across divisions is fully observable, the allocation of intangible resources is only partially observable. The divisions differ in how informative of their cash flows are about managerial ability. The manager maximizes perceived ability. In this set up, we show that divisions with more informative cash flows about the manager's ability receive more than the first-best allocation of both capital and intangible resources. This allocation inefficiency results in conglomerates being valued less than a portfolio of single-segment firms. The paper shows that the diversification discount increases with the variance of informativeness, and the correlation, between the divisions. The discount decreases as the observability of the intangible resource allocation improves. The model also highlights a cost of segment reporting, namely, that it creates avenues for managers to distort their perceived ability at the expense of shareholders.