Internal Capital Market Efficiency Research Articles

Do Tax Incentives Affect Internal Capital Market Efficiency? Evidence from the Addback Statutes

Do Tax Incentives Affect Internal Capital Market Efficiency? Evidence from the Addback Statutes

Vertical integration to mitigate internal capital market inefficiencies

We argue that vertical integration creates operational links between divisions in a conglomerate, which aligns divisional interests, thereby reducing internal competition between divisions. As a result, vertical integration improves the capital allocation efficiency of the internal capital market (ICM). We measure ICM efficiency by innovation output and capital expenditure (CAPX) deviation, and present evidence that higher levels of vertical integration are associated with higher ICM efficiency. Our results are robust to a number of endogeneity tests and the use of alternative measures of vertical integration and ICM efficiency.

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.

Corporate Headquarters and a Tradeoff in Diversification Strategy

The roles of structure in corporate strategy are a central issue of strategic management. However, systematic evidence on this topic is seriously lacking. Based on a panel of Japanese firms, we contribute to filling the void by studying the causes and consequences of the variation of headquarters’ size across firms. Consistent with the view that firms enlarge headquarters to profit from operating synergy based on inter-divisional resource sharing, we find that firms with higher R&D and advertising intensities and firms with a more related business portfolio have larger headquarters. However, the size of headquarters is inversely associated with internal capital market efficiency, suggesting that large headquarters handicap firms in profiting from financial synergy. These results lend credence to the notion that firms cannot be ambidextrous in profiting from diversification because of distinct structures required for operating and financial synergies.

Managerial Discretion and Efficiency of Internal Capital Markets

This paper uses the staggered adoption of state-level antitakeover laws to provide causal evidence on whether managerial agency problems affect the allocative efficiency of conglomerate firms. Increases in control slack lead to sharp declines in the Q-sensitivity of investment. The effects are more pronounced for conglomerate firms under stronger pressure from the corporate control market prior to the adoption of antitakeover laws as well as for conglomerate firms with greater financial slack, dispersion of ownership, and diversity of investment opportunities. Our findings establish a novel organizational channel through which takeover threats impact the efficiency of resource allocation in the economy.

Allocative Efficiency of Internal Capital Markets: Evidence from Equity Carve-outs by Diversified Firms

We examine whether equity carve-outs (ECOs) lead to improvements in the functioning of the internal capital markets (ICM) of diversified firms. Divestments, including spin-offs, sell-offs and ECOs, can be employed by firms to improve allocative efficiency. Equity carve-outs, unlike spin-offs and sell-offs, leave the parent’s ICM intact but provide the opportunity to enhance internal and external corporate governance mechanisms. Using a US sample of 354 ECOs completed between 1980 and 2013, we find that the allocative efficiency of parents is augmented significantly following ECOs. This increase in allocative efficiency is driven by improvements in the governance characteristics of parent companies.

The hedging benefits of industrial and global diversification: Evidence from economic downturns

AbstractIn a large panel of US firms, we find that discounts for industrial and global diversification significantly decrease in economic downturns, suggesting a valuable hedging benefit of diversification. This finding is robust to a wide variety of business cycle and economic uncertainty variables and persists when we account for endogeneity of industrial and global diversification. We further analyze the channels through which diversification is more valuable in economic downturns. We find that the value improvement is largely explained by increases in investment and product market performance relative to focused firms. There is no evidence that improved internal capital market efficiency or access to external finance contribute to the hedging value of diversification.

Diversification, Internal Capital Market, and Information Advantage

We analyze the information advantage of insiders and institutional investors from the efficiency of internal capital market defined in Billett and Mauer [1]. The empirical evidence shows three major findings in this paper. First, the inefficient subsidies to constrained firms have significantly negative impact on the firm’s long-term performance. In addition, the diversified firms with transfer segments, both efficient and inefficient transfer, have significantly positive effect on the firm’s performance. Second, the insiders and institutional investors of diversified firms may use similar information regarding the internal capital market because they show the similar trading behavior with respect to efficient subsidies to both constrained and non-constrained segments. Finally, the insiders play a more important role in the firms’ long-term performance. In sum, we conclude that both institutional investors and insiders have some information advantage of internal capital market. Insiders, however, have stronger impact on the diversified firms’ long-term performance.

Roles and Effects of Corporate Headquarters

The roles of headquarters in multi-business firms are a central issue of corporate strategy. However, systematic evidence on this topic is seriously lacking. Based on unique governmental data, this article contributes to filling the void by studying the headquarters of Japanese firms. We find strong evidence for the conflicting roles of headquarters. On the one hand, firms with higher R&D and advertising intensities have larger headquarters, consistent with the notion that these organizational units help to generate operating synergy by promoting inter-business resource sharing. On the other hand, the size of headquarters is inversely associated with internal capital market efficiency, suggesting that a large central office reduces a firm's ability to profit from financial synergy. Despite the tradeoff implies by these results, larger headquarters are on average valued higher by investors. We find little evidence that headquarters grow excessively large.

Internal capital market efficiency and the diversification discount: The role of financial statement comparability

AbstractThis paper investigates how financial statement comparability affects the efficiency of internal capital markets and diversification discounts in multi‐segment firms through monitoring mechanisms. Previous studies suggest that financial statement comparability improves transparency and reduces the cost of information processing, mitigating information asymmetry between managers and shareholders. Using measures of comparability and internal capital efficiency, we find that financial statement comparability has a strong positive influence on internal capital market efficiency. Further, we find that by improving the efficiency of internal capital markets, financial statement comparability indeed mitigates diversification discounts. Especially, the effect of financial statement comparability is more pronounced for firms with high information asymmetry or operating environment volatility. The results support our arguments that financial statement comparability enhances the efficiency of internal capital markets and increases firm value in diversified firms by mitigating agency problems via monitoring and corporate control mechanisms.

The Relevance between Group's Internal Capital Market and Cash Holdings: Based on the Moderating Effect of Bank Debt’s Intervention

Based on the monitoring effect of creditors, this paper examines the relevance between group’s internal capital market and cash holdings. We find that the groups have become the economic pillar organization in China, but groups’ internal capital markets generally exist the inefficient phenomena. We further find that the group's members on average have more cash holdings than independent companies and the moderating effect of bank debt’s intervention can strengthen the negative relevance between internal capital market and cash holdings. Our findings suggest that groups should follow the pace of economic reform to enhance efficiency of internal capital market and reduce cash holdings by the way of appropriate bank debt.

Board Independance and The Efficiency of Internal Capital Markets

The Sarbanes-Oxley Act of 2002 and exchange listing requirements led to an increase in the percentage of independent members on company boards. The literature offers mixed evidence on the effect of board independence on corporate governance. Independent directors are said to improve the monitoring role of the board of directors. However, the presence of independent directors increases costs associated with information asymmetry and free riding problems. Accordingly, the firm's board monitoring efficiency is expected to have a significant impact on managerial decisions and the allocation of the firm's scarce resources across the different firm segments. We investigate the effect of increased board independence on the efficiency of internal capital markets in diversified firms. Data is collected from the Compustat, ExecuComp, and RiskMetrics databases. Sample is split into 2 sub-periods: (i) Pre-SOX (1996 – 2001); and (ii) Post-SOX (2003-2008). We also divide our sample into two subsamples: (i) Firms that were not in compliance with the independence requirements prior to SOX and became complying afterwards; and (ii) Firms that were already in compliance with the new requirements before SOX. We employ Berger and Ofek's (1995) method by calculating the imputed values of a given firm's segments and comparing the sum of those values to the value of the firm. Internal capital market efficiency is measured following Rajan, Servaes, and Zingales (2000). We find that the increase in board independence post-SOX may have moved firms away from their optimal board structure. Our results suggest that, relative to the pre-SOX period, increased board independence post-SOX had a negative effect on diversified firms' excess value and internal capital market efficiency. The results apply to both subsamples: (i) firms that were previously compliant; and (ii) those that weren't compliant with the mandates. This suggests that firms may not have benefited from the move towards higher independence in the post-SOX era. Mutual back scratching and socialization within the firm may explain the ineffectiveness and inefficiency of increased board independence in diversified firms. The passed legislations may have had a converse effect on corporate boards. Our results are consistent with Linck, Netter, and Yang (2008) who propose that a one-size-fits-all regulation may be inefficient and could move firms away from their optimum board composition.

Corporate Governance and the Efficiency of Internal Capital Markets

This study investigates whether the governance structure of a diversified firm affects its internal capital market and the associated investment efficiencies. We propose that managers of well-governed diversified firms are more subject to the disciplinary power of shareholders and thus are less likely to undertake the inefficient capital investment between divisions. We find that the small segment investment of well-governed diversified firms has less sensitivity with regard to cash flows, but is more sensitive to growth opportunities. Our empirical results suggest that governance mechanisms play an important role in capital allocation among divisions of diversified firms.

Organizational Forms and Internal Capital Market: Evidence from the U.S. Property and Liability Insurance Industry

We examine how organizational forms affect the performance of internal capital markets (ICMs), one of important activities in the business group setting. Specifically, we study the difference in the size and efficiency of ICMs between mutual and stock firms. We measure the size of ICMs using net reinsurance ceded to affiliated companies and evaluate the efficiency of ICMs by investigating the relationship between ICM transfers and investment in lines of high and low profitability. We find that mutual firms have smaller size of ICMs. Mutual firms’ ICMs have lower ability to facilitate investment in highly profitable lines of business. The evidence indicates the heterogeneity of ICM efficiency across different forms of organization in P&L insurance industry.

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.

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.

SEO announcement returns and internal capital market efficiency

We test the hypothesis that efficient internal capital markets mitigate the negative announcement returns surrounding seasoned equity offerings (SEOs). Our predictions are based on the argument that efficiency reduces uncertainty regarding the value of assets-in-place. Having established the inverse association between our efficiency measures and uncertainty, we show that the efficiency measures are positively associated with SEO announcement returns, particularly among firms with multiple segment codes. The positive relation suggests that efficiency mitigates uncertainty regarding the value of assets-in-place, and this is the channel through which more favorable announcement returns are produced in response to the SEOs of high efficiency firms.

Compensation Incentive of CEO and Internal Capital Market Allocation Efficiency

In the agency theory of internal capital market, the compensation incentive of Headquarters is discussed as a key factor to the efficiency of internal capital market, using KKT. Assumed that equity incentive and investment incentive are Headquarters’ compensation body, investments in divisions are decided by the comparison between equity incentive and investment incentive, the comparison results in internal capital market “Socialism”. Furthermore, for the maximum of equity incentive and investment incentive, Headquarters prefers to overinvestment in divisions.

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

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.

Chasing Their Tails: Why Do Firms Subsidize Underperforming Business Units?

Firms repeatedly fail to exit from underperforming lines of business. To explore the managerial motives of exit delay, this paper joins theory on scope economies and real options with a theory of internal capital market efficiency. I show that economies of scope, along with characteristics of the firm’s chief executive officer (CEO), play a significant role in the managerial decision to delay exit from an underperforming line of business. In the final stage of the analysis, I present evidence that managers may be overestimating the scope economies and option values behind their investment decisions, and that these decisions may also be subject to an escalation of commitment.