The Power Game between Division Managers and CEOs in Internal Capital Market

Abstract

Scharfstein and Stein (2000) propose a two-tiered agency model where division managers rent-seek to maximize their own utilities; the CEO being an agent of shareholders may use preferential capital allocation to retain division managers. We build our study on this two-tiered agency model and show empirically that: factors that improve division managers’ bargaining power (such as segment profitability or segment requires specific human capital) or increase productivity imbalance (such as variation in segment productivities) among segments tend to aggravate distortion in internal capital allocation; while factors that contribute to stronger CEO power (such as high CEO ownership), easy segment evaluation (such as segment asset tangibility) tend to improve the efficiency in internal capital market. We also find that segment financial opacity and equity-based CEO compensation distort capital reallocation decisions when there are changes in segment investment opportunities. Overall, our results indicate that the relative bargaining positions of conglomerate CEOs and segment managers play an important role in determining the efficiency of internal capital market.