Internal Capital Allocation Research Articles

Oil price uncertainty and excess value of diversification

PurposeThis study examines the value implications of oil price uncertainty for investors in diversified firms using a sample of 922 USA firms from 2001 to 2019.Design/methodology/approachOur study employs a panel dataset to examine the value implications of oil price uncertainty for diversified firm investors. We consider several alternative specifications to account for unobserved factors and measurement errors that could potentially bias our results. In particular, we use alternative measures of the excess value of diversified firms and oil price uncertainty, additional control variables, fixed-effects models, the Oster test, impact threshold for confounding variable (ITCV) analysis, two-stage least square instrumental variable (2SLS-IV) analysis and the system-GMM model.FindingsWe find that the excess value of diversified firms, relative to a benchmark portfolio of single-segment firms, increases with high oil price uncertainty. The impact of oil price uncertainty is asymmetric, as corporate diversification is value-increasing for diversified firm investors only when the volatility is due to positive oil price changes and amidst supply-driven oil price shocks. The excess value increases irrespective of diversified firms’ financial constraints and oil usage. Diversified firms become conservative in their internal capital allocations with high oil price uncertainty. Such conservatism is value-increasing for diversified firm investors, as it supports higher performance in response to oil price uncertainty.Originality/valueOur study has three important implications: first, they are relevant to investors in understanding the portfolio value implications of oil price uncertainty. Second, they are helpful for firm managers while comprehending the value-relevant implications of internal capital allocations. Finally, our findings are policy relevant in the context of the future of diversified firms in developed markets.

Macroeconomic fluctuation and internal capital allocation in business group

In this paper, we use dataset of internal capital markets (ICM) between 2007 and 2019 to explore the mechanism of applying macroeconomic policy at the micro level. We find that the macroeconomic environment affects firms that use internal capital markets to mitigate negative shocks. In this way, ICM functions as a financial buffer in times of economic recession. In addition, the effect is significant at private enterprises (PEs) and regions where financial dependence is lower. During times of economic recession, PEs is strongly motivated to use ICM to mitigate negative shocks and increase the scale of internal cash transfer. Furthermore, firms in regions with a lower level of financial dependence have stronger motivations to use ICM and at a larger scale.

Trust-and-Evaluate: A Dynamic Nonmonetary Mechanism for Internal Capital Allocation

To stay competitive, firms regularly invest in innovation by supporting internal capital projects (funded and executed in-house) that explore new products and operational improvements. Each year, in a highly competitive process, managers from different functional units of the firm submit proposals (that include estimated costs and benefits) for such projects. Managers, because of their domain knowledge and expertise, are naturally better informed about the costs and benefits of their respective projects and can use this information strategically to secure funding. An example of such behavior is the under-reporting of the cost estimate of a project and subsequently requesting additional funding during the execution phase. Such strategic behavior not only affects the firm’s ability to fund the best projects but is also costly. Motivated by this challenge of deciding the funding of such projects at a global agribusiness firm, we seek a mechanism that is both provably near-optimal for the firm and guarantees truthful reporting from managers. Our setting consists of a principal and multiple agents. In each time period, over an infinite horizon, each agent requests funding for a potential project from the principal. Before submitting his proposal, each agent privately estimates the project’s cost and its benefit. If funded, each project is executed in one period. The principal’s funding decisions are binary; that is, each project is either funded in full or not funded. The actual cost (benefit) of a funded project is realized on its completion and incurred (earned) by the principal. The agents earn utility from the experience and reputation gained in completing projects. In each period, the principal desires to keep the total spend below a budget but can borrow external money at a cost. Our main contribution is a practically appealing dynamic nonmonetary mechanism for internal capital allocation under which, for any [Formula: see text], (a) truth-telling forms an ϵ-Bayesian Nash equilibrium and (b) the principal’s expected utility is within ϵ of the expected utility in the first-best setting. This paper was accepted by Karan Girotra, operations management. Supplemental Material: The online appendices and data files are available at https://doi.org/10.1287/mnsc.2022.01121 .

The role of the dual holder in mitigating underinvestment

AbstractThe literature on dual holding focuses exclusively on cases where the holder is primarily a creditor and buys the firm's stocks to reduce potential wealth transfer. However, wealth transfer is not a concern when the dual holder is a stockholder first and becomes a bondholder later. We hypothesize that the principal motive behind such dual holdings is to provide debt funding to an otherwise successful firm that cannot fund good projects because of internal capital allocation problems coupled with external capital constraints. We select samples from multinational corporations based on evidence that these firms are exposed to domestic underinvestment because they are reluctant to bring back foreign profits to avoid repatriation taxes. We choose hedge funds (HFs) as dual holders. The treatment group comprises firms where HFs are dual owners, and the control group comprises firms in which HFs own stocks only. The treatment group experiences steeper financial constraints, leading to deeper underinvestment problems and causing target firms to seek HF funding. The funding corresponds well to the amount of underinvestment. Targets improve investment efficiency by alleviating underinvestment, surpassing their predual performance and the control group's postdual performance.

Do insurers use internal capital markets to manage regulatory scrutiny risk?

AbstractEmpirical evidence suggests that insurance groups allocate capital to members with better performance or growth prospects and use internal capital markets (ICMs) to protect the franchise value of less capitalized members. We propose and test an additional motivation for the use of ICMs—to manage regulatory scrutiny risk. We show that almost 50% of insurers at risk of facing additional regulatory scrutiny due to failing four Insurance Regulatory Information System (IRIS) ratios received sufficient internal capital to avoid enhanced regulation. Moreover, the likelihood and extent of internal capital allocation are related to regulatory scrutiny risk and the amount of capital allocated is typically just enough to avoid regulatory scrutiny. Time series evidence indicates that groups manage regulatory scrutiny risk by allocating capital toward affiliates when their pre‐capital contribution IRIS ratio failures exceed three, and away from affiliates when they are no longer at risk of additional regulatory scrutiny.

Do Managers Learn from Analysts about Investing? Evidence from Internal Capital Allocation

ABSTRACTAnalysts are recognized for their expertise in predicting industry growth, yet little is known about whether CEOs learn from analysts’ insights to guide investment decisions. Focusing on conglomerates where CEOs are underinformed about segment growth opportunities, we find that CEOs learn industry insights from analysts to adjust internal capital allocation. The extent of learning increases when analysts have closer proximity to CEOs or expertise in segments where CEOs face larger internal knowledge gaps. CEOs likely learn from analysts through private communications, as the insights learned are not yet publicly available, difficult to replace with other sources, and persistently impactful for firms. CEOs also exploit conference calls as another way to learn from analysts. As a result, learning analysts’ insights enhances firm value. We employ brokerage mergers/closures as a quasi-experiment to address endogeneity concerns. Overall, our study provides novel evidence on a learning channel through which analysts add value to firms.JEL Classifications: D80; D83; G10; G31.

Ruminate the Significance of Internal Capital Market to enterprise capital control

Internal capital market theory is one of the most essential theories for studying the internal management of enterprises. It fundamentally solves the problem of information asymmetry in the external market and optimizes the internal resource allocation of enterprises while reducing transaction costs. This paper analyzes the impact of internal capital allocation and endogenous financing from the perspective of internal capital market theory which improve the centralized management of corporate capital and enhance the overall value of corporate groups.

Inexperienced Component Auditors and the Internal Information Asymmetry of Multinational Corporations

With the global expansion of business operations, many U.S. corporations now operate internationally. While these multinational corporations (MNCs) rely on information about their operations to allocate resources, this information is likely dispersed within the firm, leading to internal information asymmetry between top executives and divisional managers. Meanwhile, audits of these geographically dispersed MNCs are challenging, and parts of these audits are sometimes outsourced to local foreign auditors who have no experience serving as opinion-issuing auditors for U.S. issuers (“inexperienced component auditors”). In this article, we examine whether involving such inexperienced component auditors is associated with MNCs’ internal information environment. We find that, relative to a matched control sample, Securities and Exchange Commission (SEC) issuers with the participation of inexperienced component auditors have higher internal information asymmetry and lower internal capital allocation efficiency. Our results suggest that audit quality matters not only to a firm’s external financial statement users but also to its internal users.

Internal capital allocation in IPOs and corporate innovation: The moderating role of political connections

AbstractWe explore the effect of initial public offering (IPO) capital allocation on corporate innovation. We document that IPOs enhance corporate innovation through allocation of internal capital to innovative projects. While political connections moderate the IPO‐innovation relation in that connected firms allocate less IPO capital to innovative projects and are more likely to reallocate their resource from innovative to non‐innovative projects. Resource allocation to innovative projects results in better post‐IPO performance, especially in non‐connected firms. Overall, this study identifies intra‐firm capital allocation as an important factor that contribute to firm innovation and the distortion of resource allocation linked to political ties.

Allocation of Decision Rights and CSR Disclosure: Evidence from Listed Business Groups in China

Corporate social responsibility (CSR) research has recently begun to focus on the CSR performance of business groups, with the scope shifting from group members to business groups in general. This paper focuses on whether business groups with centralized decision rights tend to disclose more CSR information and investigates the heterogeneous effect of the number of subsidiaries. Using a dataset for listed groups in China from 2010 to 2020, our empirical test discovered that centralized decision rights could promote group CSR disclosure. For groups with many subsidiaries, centralization makes a more significant contribution to promoting CSR disclosure. The mechanism test revealed that this positive relationship between centralization and disclosure relies on efficient internal capital market allocation, a reduction in rent-seeking behavior of subsidiaries, and reputational concerns. Furthermore, we observed that the centralized decision rights influence on disclosure varies across different aspects of CSR, with a negative impact on “Social Contribution” and a positive impact on “Shareholder Responsibility”, “Employee Responsibility”, “Supplier, Customer, and Consumer Responsibility” and “Environmental Responsibility”. Centralized decision rights promote more CSR disclosures with voluntary disclosures, while regulatory disclosures have no significant effect. We research the allocation of decision rights and group CSR disclosure.

Sharia-Compliance, Internal Capital Allocation and Investment Policy: Evidence from Malaysia

Sharia-Compliance, Internal Capital Allocation and Investment Policy: Evidence from Malaysia

Do Managers Learn from Analysts about Investing? Evidence from Internal Capital Allocation

Do Managers Learn from Analysts about Investing? Evidence from Internal Capital Allocation

Trust-and-Evaluate: A Dynamic Non-Monetary Mechanism for Internal Capital Allocation

Trust-and-Evaluate: A Dynamic Non-Monetary Mechanism for Internal Capital Allocation

Owners’ portfolio diversification and internal capital allocation

Using data on Taiwanese public firms from 2000–2017, this study demonstrates that firms’ capital investment decreases in controlling owners’ portfolio diversification. Causal evidence is obtained by exploring an exogenous shock that constrains the ability of shareholders to diversify. This relationship is attributable to the presence of an internal capital market among firms that share common ownership, which facilitates resource tunneling to affiliated entities. Consistent with the hypothesis, we find that the main effect is stronger when the internal capital market is more active and that the sensitivity of cash dividend payout to the firm's earnings increases in owners’ diversification.

Corporate‐level influences on internal capital allocation: The role of financial analyst performance projections

AbstractResearch contends that internal capital should be allocated in proportion to divisional performance, but scholars are often puzzled to find that managers do not adhere to this winner‐picking approach. We argue this is because scholarship has not incorporated corporate‐level factors that influence how corporate managers structure holistic capital allocation strategies. In this study, we build on the behavioral theory of the firm to focus on analyst performance projections for multidivisional corporations and how they inform corporate managers' allocation strategies. Specifically, we theorize corporate managers deviate from the winner‐picking allocation approach owing to search‐related behaviors stemming from projected performance below or above expectations. We further theorize about conditions that offer corporate managers opportunities to deviate from winner‐picking, focusing particularly on multidivisional relatedness and asset durability.

CEO inside debt and internal capital market efficiency

Agency theory argues that managerial equity-based incentives are more effective when firm solvency is likely while debt-based incentives are more effective when firms face a greater likelihood of bankruptcy. We examine the relation between chief executive officers' (CEOs') inside debt holdings and the internal capital market allocation of multi-segment firms. We find that CEO inside debt holdings are associated with conservative capital allocation to firm segments, with the result driven by financially distressed firms. Further analysis indicates that although CEO inside debt, on average, is negatively related to firm value, the relation is positive for financially distressed firms. Our evidence indicates that inside debt holdings align the interests of managers and external creditors, inducing managers to pursue conservative capital allocation strategies that appear to be optimal for firms facing insolvency.

Group firms’ access to internal capital markets: The contingent roles of group resources and affiliates’ financial weakness

This study investigates how group’s value maximization considerations determine affiliates’ access to internal capital. Previous studies have indicated that both the amount of group resources and affiliates’ financial weakness are relevant to internal capital allocation decisions. Our study investigates how these two factors jointly affect affiliates’ access to internal capital. By analyzing the effects of capital shortage on various financing channels in the context of insurance groups, we reveal that financially-weak firms’ capital shortage positively affects the receipt of internal capital when groups own abundant resources. Conversely, when the amount of group resources is limited, those affiliates enjoying better financial conditions receive more internal capital to manage their capital shortage, and financially-weak ones do not; thus, such financially-weak firms exhibit increased tendency to use costly external capital to manage their capitalization. Our findings indicate that groups with less abundant resources tend to engage in “winner-picking” allocation decisions to maximize value.

The impacts of internal capital allocation efficiency on R&D investments: evidence from China

ABSTRACT This research utilizes hand-collected data on business groups’ pyramidal equity structure to examine the impacts of internal capital markets on research and development (R&D) investments in China. Empirical findings show that the allocation efficiency of the internal capital market positively correlates with R&D investments. We further provide evidence of a U-shape relationship between pyramidal layers and R&D investments for state-owned business groups. For non-state-owned business groups, however, there is an opposite impact pattern on the relation between internal capital markets and R&D investments.

Firm Vertical Boundaries, Internal Capital Markets, and Firm Performance

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.

Business Group Dominance and Capital Allocation Externalities: Evidence from Korean Chaebols

This study investigates how dominant business groups affect investment decisions of other standalone firms in the economy. Using intra-group equity transactions within the top 40 largest business groups in Korea, this study finds that high levels of internal capital allocation within the groups exert a negative influence on investments of standalone firms that require external capital. Due to financial market imperfections associated with low investor protections, business groups prefer internal investment rather than outside investment. However, when internal capital allocation is prevalent in the economy, lots of capital is trapped inside business groups and available capital in external markets becomes scarce. Standalone firms outside business groups have difficulties raising external finance and thus reduce investment. The negative influence on investments of business group dominance is particularly pronounced for private standalone firms and the firms that hold fewer tangible assets. Findings in this study suggest a negative externality that business groups impose on other standalone firms: the bias toward internal investment makes it harder for good projects outside business groups to obtain capital.