Internal Capital Allocation Research Articles

Organizational Structure, Voluntary Disclosure, and Investment Efficiency

An important role of corporate disclosure is to improve the efficiency of capital allocation, and a key part of this process is firms’ internal allocation of capital across their multiple projects. This paper examines the effect of internal capital allocation on firms’ disclosure incentives and how these incentives affect internal capital allocation and investment efficiency. I identify conditions under which the multi-project firm that can perform internal capital allocation withholds more information than a group of stand-alone firms. Under these conditions, I show that the investment efficiency of the multi-project firm is higher than that of a group of stand-alone firms. The results suggest that corporate disclosure and internal capital allocation are substitutes in improving investment efficiency. This provides one explanation for why a multi-divisional structure may be preferred, although the structure appears inefficient.

A new approach to optimal capital allocation for RORAC maximization in banks

Abstract We introduce a new model for optimal internal capital allocation, which would allow banks to maximize their Return on Risk-Adjusted Capital (RORAC) under regulatory and capital constraints. We extend the single period model of Buch et al. (2011) to a multi-period model and improve its forecasting accuracy by including the debt effect and Bayesian learning innovations. The empirical application shows that our model significantly improves the RORAC of a sample of banks listed in the S&P 500 index.

Internal Capital Allocation at Financial Institutions

Over the past 20 years, much has been said, and then unsaid, about how risk capital should be allocated tactically inside financial institutions once strategic or regulatory capital is somehow determined. Although many of the techniques used for this purpose have proven their mettle within various institutions and contexts, the issue appears as unsettled as ever. This article takes a different tack and proposes a synthetic allocation regime combining risk and return, whereby value at risk and a measure of net operating income are the inputs to a reformulated Sharpe ratio driving the allocation. This first step is then combined with a weight-optimization step centered on the Chebyshev polynomial’s minimax property. The authors believe that resolving the internal allocation dilemma lies first in not focusing exclusively on either risk or return as the main driver but rather on their ratio, and second, in objectively and transparently avoiding the boundaries of the domain. Finally, although initial capital allocations should be made without regard for the size of the available market, ultimately one is compelled to pay homage to the prevailing macroeconomic reality. A detailed example of the approach and the mathematical rationale underlying Chebyshev optimization are included as separate appendices. TOPICS:VAR and use of alternative risk measures of trading risk, performance measurement, legal/regulatory/public policy, quantitative methods

The Effect of Audit Quality on a Firm’s Internal Information Environment: Evidence From Group Audits

Many U.S. corporations operate internationally. For instance, S&P 500 firms generate approximately 29 percent of their sales in foreign markets (Brzenk 2018). Multinational corporations (MNCs) rely on information about their operations to allocate resources. This information is dispersed within the firm, which could lead to internal information asymmetry (IIA) between executives and divisional managers. Meanwhile, audits of 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. We examine whether involving such auditors affects MNCs’ internal information environments. We find that, relative to a matched control sample, SEC issuers employing inexperienced auditors have higher IIA and lower internal capital allocation efficiency. Together, the associations we document extend prior literature by providing some evidence that audit quality matters not only to a firm’s external financial statement users but also its internal users.

The Role of Firm Performance Aspirations in Managers' Internal Capital Allocation Strategies

Despite the strong conceptual relationship between internal capital allocation decisions and firm performance, scholars understand little about the influence firm performance has on managers’ capit...

The distribution of the Capital Purchase Program funds: Evidence from bank internal capital markets

AbstractWe investigate the role played by the internal capital markets of bank holding companies in the distribution of the Capital Purchase Program funds to subsidiaries. We find that while all banks used a similar internal capital allocation to support their subsidiaries, program participants transferred more capital to their subsidiaries than nonparticipants. Smaller bank subsidiaries with lower capital and earnings received more capital than other subsidiaries. Our results support the argument that the distribution of capital was done in accordance with regulatory requirements that mandate bank holding companies to act as a source of strength for their subsidiaries.

CEO Duality, Agency Costs, and Internal Capital Allocation Efficiency

AbstractThis study examines the impact of CEO duality on firms’ internal capital allocation efficiency. We observe that when the CEO is also chair of the board, diversified firms make inefficient investments, as they allocate more capital to business segments with relatively low growth opportunities over segments with high growth opportunities. The adverse impact of CEO duality on investment efficiency prevails only among firms that face high agency problems, as captured by high free cash flows, staggered board structure and low board independence. Depending on the severity of the agency problem, CEO duality is associated with a decrease in industry‐adjusted investment in high‐growth segments of 1% to 2.1% over the following year, relative to that in low‐growth segments. However, CEOs’ equity‐based compensation curbs the negative effect of CEO duality on internal capital allocation efficiency. Overall, the findings of this study offer strong support for the agency theory and postulate the internal capital allocation policy as an important channel through which CEO duality lowers firm value in diversified firms.

Financial reporting changes and the internal information environment: Evidence from SFAS 142

Using the adoption of SFAS 142 as an exogenous shock, we examine the effect of changes in financial reporting on firms’ internal information environment. We argue that complying with SFAS 142 induces managers to acquire new information and therefore improves their information sets. Interviews with executives and auditors confirm this argument. Using a difference-in-differences design, we find that firms affected by SFAS 142 (i.e., treatment firms) experience an improvement in management forecast accuracy in the post-SFAS 142 period. The increase is smaller for those with stronger monitoring in the pre-SFAS 142 period and greater for those with a higher likelihood of goodwill impairment. Furthermore, treatment firms with improvements in management forecast accuracy have higher M&A quality, internal capital allocation efficiency, and performance in the post-SFAS142 period. Overall, our findings indicate that changes in external financial reporting can lead to better corporate decisions via their impact on the internal information environment.

Internal Information Quality and Capital Allocation within Conglomerates

Theoretical research on internal capital markets suggests an important role for internal information quality in the capital allocation process within conglomerates. Direct empirical evidence, however, has been sparse, largely because informational frictions inside firms are difficult for researchers to observe and measure. We leverage public reporting on internal control effectiveness mandated by the Sarbanes-Oxley Act of 2002 and recent developments in the accounting literature to provide evidence that the quality of the internal information environment is positively associated with the efficiency of internal capital allocation. We find that firms with internal control weaknesses allocate internal capital less efficiently than firms without weaknesses, and that allocation efficiency improves following the remediation of control weaknesses, to a level similar to firms without weaknesses. We document similar results using other recently developed proxies for internal information quality, suggesting that our inferences are not confined to internal control issues, but rather are related to internal information quality more generally. We also show that internal information quality plays a particularly important role for firms with diverse operations and during periods of economic expansion, when misallocation due to agency and information frictions tends to otherwise be more severe.

Capital Allocation Based Asset Pricing

I explore an intricate interaction between a firm’s risk exposure, intangible capital accumulation, and physical capital accumulation by using a unified dynamic investment model of capital allocation. The model emphasizes both the importance of the marginal value of the intangible capital and the idiosyncratic risk for corporate decisions, then implicates the firm value and expected returns. A model feature that the good idiosyncratic volatility is endogenously generated, but bad idiosyncratic volatility does not. The model provides several implications: (1) high bad idiosyncratic volatility lowers the firm’s profitability, expected returns, and Tobin’s q due to risk management and capital misallocation. Typically, this effect is much stronger in value firms; (2) there is a positive interaction between the value effect, profitability effect, and momentum. The idiosyncratic volatility can also affect the other anomalies indirectly via a complicated interaction between the corporate investment, internal capital allocation, and risk management, which implies that the idiosyncratic risk is priced indirectly as well; (3) high-tech firm invests more in intangible capital, holds more cash, and finds it much harder to achieve its growth firm region than low-tech firm. This result applies to firms with high idiosyncratic volatility as well.

Financial Reporting Changes and the Internal Information Environment: Evidence from SFAS 142

Using the adoption of SFAS 142 as an exogenous shock, we examine the effect of changes in financial reporting on firms’ internal information environment. SFAS 142 removed goodwill amortization and required firms to perform a two-step impairment test. We argue that complying with SFAS 142 induces managers to acquire new information and, therefore, improves managers’ information sets. Interviews with executives and auditors confirm this argument. Using a difference-in-differences design, we find that firms affected by SFAS 142 (i.e., treatment firms) experience an improvement in management forecast accuracy in the post-SFAS 142 period compared with those not affected. The increase is smaller for treatment firms with stronger monitoring mechanisms in the pre-SFAS 142 period and greater for firms with a higher likelihood of goodwill impairment. We further find that treatment firms with improvements in management forecast accuracy have higher M&A quality, internal capital allocation efficiency, and performance in the post-SFAS142 period than other treatment firms. Overall, our findings indicate that changes in external financial reporting can lead to better corporate decisions via their impact on the internal information environment.

A Review of the Internal Capital Allocation Literature: Piecing Together the Capital Allocation Puzzle

Allocating internal financial capital represents a key task for managers of multidivisional corporations. This has led to a wealth of research and theorizing about capital allocation and whether or not managers allocate capital successfully. However, capital allocation research has diverged in a number of directions that reflect different and often incompatible perspectives, underlying frameworks, and outcomes. The result is a puzzle, wherein scholars have found little consistent substantive relation between capital allocation, business unit characteristics, and firm performance. Through our review, we seek to bring clarity to this puzzle by identifying problems in the literature and by offering a solution. We suggest problems in the literature stem from the disparate approaches scholars have taken when studying capital allocation, including assessments of what constitutes and prevents successful allocation. We begin by organizing these approaches into a framework that highlights key allocation strategies and the primary impediments to allocation success that scholars have used to build their models. We then suggest that managers may employ a number of allocation strategies and that scholars need to recognize that not all corporate managers employ the same strategy. We contend that a resurgence of obtrusive, qualitative, and multilevel studies may help explain why managers select one strategy over another. Ultimately, we recommend scholars delve into the black box of organizations to truly understand capital allocation.

Cash Conversion Systems in Corporate Subsidiaries

This paper models a cash conversion system in a subsidiary of a parent company where there is an active internal capital market, but otherwise the subsidiary has no access to additional external funds. The cash conversion system consists of a treasury, a single-product make-to-stock inventory, and a receivables pool. It implements a perpetual flow cycle, where funds convert to product and back to funds. The system is stationary, and revenues and costs flow directly to the parent company. The parent company aims to maximize equilibrium (long-run) financial metrics in terms of net profit rate and rate of return. To this end, we model this system as a discrete-state continuous-time Markov process and compute its equilibrium state distribution using analytic and numerical methods. These are then used to derive statistics of the equilibrium cash conversion cycle and define equilibrium financial rate metrics and cumulative counterparts that incorporate the time value of money. We further optimize the financial and operational designs of the system and, specifically, the internal capital allocation and inventory base stock level. Finally, noting the potential for friction in the parent–subsidiary relationship, we study numerically the impact of moral hazard and internal capital market inefficiency on optimal designs. The online appendix is available at https://doi.org/10.1287/msom.2017.0625 .

Strong shareholder rights, internal capital allocation efficiency, and the moderating role of market competition and external financing needs

This study investigates the effect of strong shareholder rights on the internal capital allocation efficiency of multi-segment firms and how market competition and the firm’s need for external financing moderate this association. For this purpose, we use panel data from North American multi-segment firms covering the years 1998 through 2006 with dynamic firm fixed effect models, which enable us to control for unobserved and time-invariant firm heterogeneity as well as for a dynamic nature of the internal capital allocation process. We confirm previous findings of Chen and Chen (J Bank Finance 36(2):395–409, 2012) and show that strong shareholder rights significantly increase the internal capital allocation efficiency. Further, we find that market competition moderates this association by significantly weakening this positive effect. However, the moderating effect of external financing needs is not found to be significant. These findings indicate that strong shareholder rights are crucial for ensuring efficient internal capital allocations within multi-segment firms, especially when market competition is low.

A Unified Tobin's q Theory of Investment Structure, Capital Allocation, Risk Management, and Asset Pricing

I propose a tractable model integrating dynamic internal capital allocation with imperfect patent protection, thereby endogenizing patent war as well as financing constraints. I emphasize the central importance of capital intangibility for corporate decisions when intangibles are insecure. The main results are: (1) relative to the first- best, imperfect patent protection introduces the non-diversifiable patent risk as a new factor for internal capital misallocation; (2) the firm manages patent risk via patent portfolio management, litigation, and patent insurance; (3) the endogenous capital reallocation can diminish the impact of the imperfect patent protection; (4) firms on the verge of liquidation tend to use patent litigation to alleviate financial distress; (5) endogenous technology choice play an important rule in patent portfolio management, and (6) imperfect patent protection creates the wedge between average q and marginal q, yet this wedge will be diminished when the firm’s intangibility is high. Remarkably, this paper extends the Modern Portfolio Theory to the real investment case.

Managerial incentives for risk-taking and internal capital allocation

In this study, we show that the option-like structure of equity-based compensation encourages managerial risk-taking and provide new evidence on the way in which CEO’s risk-taking could manifest itself in a multi-segment firm. Our results show that a greater sensitivity of managerial compensation to shareholder wealth—as proxied by CEO’s portfolio vega—leads to greater risk-taking through active capital allocation. We then analyze the impact of risk-taking on shareholder wealth and demonstrate that risk-taking is positively associated with future stock returns. Overall, this article contributes to the literature by providing evidence that equity-based compensation does actually promote the alignment of interests between shareholders and managers.

Internal control and internal capital allocation: evidence from internal capital markets of multi-segment firms

We investigate the impact of internal control over financial reporting on management decisions in directing corporate resources to alternative investment projects in multi-segment firms. Results from cross-sectional and inter-temporal analyses indicate that internal control weaknesses (ICWs) are associated with distortionary internal capital allocations. The adverse impact on internal capital markets is more pronounced for firms with company-level ICWs. Our analyses also show that firms with weak existing governance mechanisms benefit more from maintaining effective internal control. We further document that the negative impact of ICWs on firms’ internal capital transfers manifests in a lower excess value of diversification.

CEO Duality, Agency Costs, and Internal Capital Allocations

This study examines the impact of CEO duality on investment allocation efficiency and firm value. When a CEO is also the chair of the board, the firm makes relatively more investments in business segments with low growth opportunities than do firms in which these roles are held by different individuals. Such capital (mis)allocations violate the internal capital market efficiency tenet, exhibiting negative overall value consequences. However, the adverse impact of CEO duality on investment efficiency and value prevails only in firms with low CEO compensation incentives. Overall, the findings of this study indicate that the capital allocation process is an important channel through which CEO duality lowers firm value, and compensation incentives are an important internal device to mitigate this negative value effect.

Diversification discount over the long run: New perspectives

We study the long-term trend of excess value and internal capital allocation of diversified firms from 1976 to 2013. The late 1970s and 1980s are characterized by large average diversification discount but narrow dispersion of excess value. Excess value of diversified firms becomes less negative on average after 1990, but its dispersion grows larger. In contrast, capital allocation efficiency of diversified firms converges significantly over time. Three quarters of diversified firms do not suffer from severe capital misallocation after the early 2000s. The effect of capital allocation efficiency on excess value varies over time and becomes larger in recent years.

Segment Disclosure Transparency and Internal Capital Market Efficiency: Evidence from SFAS No. 131

ABSTRACTUsing the adoption of SFAS 131, I examine the effect of segment disclosure transparency on internal capital market efficiency. SFAS 131 requires firms to define segments as internally viewed by managers, thereby improving the transparency of managerial actions in internal capital allocation. I find that diversified firms that improved segment disclosure transparency by changing segment definitions upon adoption of SFAS 131 experienced an improvement in capital allocation efficiency in internal capital markets after the adoption of SFAS 131. In addition, I find that the improvement in internal capital market efficiency was greater for firms that suffered more severe agency problems before the adoption of SFAS 131 and also for firms whose managers faced stronger incentives to improve efficiency after the adoption of SFAS 131. My results suggest that more transparent segment information can help resolve agency conflicts in the internal capital markets of diversified firms, thus improving investment efficiency.