Multi-division Firms Research Articles

ITC Limited: Decoding Business Segment Betas

OCV was seeking to improve its processes and enhance the skills of its analysts so as to provide valuable solutions for their clients in terms of the issues related to the profitability and risk of their existing business portfolios as well as the proposed new projects. A team was formed to evaluate if breaking down the weighted average cost of capital (WACC) to the divisional level could improve the quality of investment decisions by multi-division firms. ITC was chosen to analyse the entire process of breaking down WACC to the divisional level. The team had three distinct tasks to undertake. The first was the calculation of the divisional WACC for different business segments of ITC, the second was an extensive discussion on the issues that could arise in the complex computations, and the third was to take a final call on whether the breaking down of WACC to the divisional level would really add value to the future investment decisions.

Organizational complexity and innovation portfolio decisions: Evidence from a quasi-natural experiment

We examine how a firm's organizational complexity affects innovation portfolio decisions in response to a shock to innovation incentives. Using the 2013 medical device sales tax as a quasi-natural experiment, we find that firms with a complex organization structure, as proxied by organization size and multi-division structure, generate fewer radical innovations (introduction of new products) but more incremental innovations (improvements on existing products) after the tax. Multidivision firms also shift capital investment to their corporate divisions that are not affected by the tax, thereby decreasing their innovation output. Collectively, these responses cause a significant decline in the radical innovation output of the industry in aggregate. We contribute to the literature by advancing the understanding of how organization structure influences managers' innovation portfolio decisions in response to economic shocks.

Managerial Compensation in Multidivision Firms

Using hand-collected data on division manager (DM) pay contracts, we document that DM pay is related to the performance of both the DM’s division and the other divisions in the firm. There is substantial heterogeneity in DM pay for performance. DM pay for division performance is lower in industries with less informative accounting earnings. DM pay is more sensitive to other-division performance if the DM’s division is related to the rest of the firm, if the DM’s division has fewer growth opportunities, and if the DM’s division receives less capital from the rest of the firm. Consistent with optimal contracting view, DMs receive greater pay for other-division performance in better-governed firms. Overall, our evidence suggests that DM compensation is structured to account for the information and agency problems in multidivision firms. The Internet appendix is available at https://doi.org/10.1287/mnsc.2016.2672 . This paper was accepted by Amit Seru, finance.

Knowledge Spillovers and Innovation in Multi-Division Firms

Knowledge Spillovers and Innovation in Multi-Division Firms

Informed Headquarters and Socialistic Internal Capital Markets*

This article develops a theory of resource allocation in internal capital markets that is consistent with the empirical finding that multidivision firms bias their investment levels in favor of divisions with weaker investment prospects. Headquarters has private information about the capital productivities of its divisions; therefore, capital allocations in the present serve as a signal to divisional managers about future allocations. To facilitate effort provision, headquarters biases capital allocation so as to not disclose productivity differences across divisions or to credibly signal their absence. The capital allocation bias is time-varying and the relationship between the bias and the difference in average division productivities is inversely U-shaped.

How Do Conglomerates Structure Division Manager Incentive Contracts?

Using hand collected data on division manager (DM) pay contracts, we document that DM pay is related to the performance of both her division and the other divisions in the firm. There is substantial heterogeneity in DM pay-for-performance. DM pay for her division’s performance is lower in industries with less informative accounting earnings. DM pay is more sensitive to other divisions’ performance if her division is related to the rest of the firm, if her division has fewer growth opportunities and receives less capital from the rest of the firm. Consistent with optimal contracting view, DMs receive greater pay for other divisions’ performance in better governed firms. Overall, our evidence suggests that DM compensation is structured taking into account the information and agency problems in multi-division firms.

Can socialism in internal capital markets occur in the absence of managerial rent seeking?

Socialism in internal capital markets (SICM) is the phenomenon whereby multi-division firms underinvest in high-profit segments and overinvest in low-profit segments. This article modifies and extends the Scharfstein and Stein (2000) model that explains SICM. The major modification is to abstract from rent-seeking behaviour – a central ingredient that is used by most SICM models and has the side effect of overturning SICM when the underlying rent-seeking game is slightly perturbed. It is shown that when division managers’ private benefits are not exactly propotional to their division's production profit, as assumed by Scharfstein and Stein (2000), SICM arises due to the CEO's incentive to extract gain from the trade of capital between his division managers by equalizing their marginal private benefits, instead of accommodating rent-seeking. Furthermore, we show that ‘diversification discounts’ exist, increase in diversity and decrease in CEO ownership. The results are robust to endogenizing the investors’ choice of the total capital provided to the firm, which allows the conditions for aggergate underinvestment or overinvestment to be determined.

Leveraging Enterprise-Wide Purchase Volumes: Optimal Supplier Assignment in Multi-Division Firms

Procurement has become a vital strategic function as firms increasingly pursue supply chain partnerships and outsourcing options. By coordinating procurement policies across multiple divisions and leveraging firm-wide purchasing power to negotiate significant volume discounts from suppliers, large firms can save millions of dollars in procurement costs. Coordinated procurement entails deciding which suppliers to use to meet each division’s purchasing needs and sourcing preferences so as to minimize overall procurement costs. Motivated by this supplier assignment problem facing a large industrial products manufacturer, we propose an integrated optimization model that simultaneously considers both corporate volume discounts and divisional order management costs. Since this large-scale integer program is difficult to solve using general purpose methods, we develop a tailored solution approach to generate tight lower and upper bounds. We derive several classes of valid inequalities to strengthen the linear programming relaxation, establish polyhedral properties of these inequalities, and develop both a cutting plane method and a sequential rounding heuristic procedure. Based on extensive computational tests for realistic problems, we demonstrate that optimally solving our integrated sourcing model can yield significant economic benefits, and establish the effectiveness of our composite solution method. The integrated approach yields average savings of 7.5% in total procurement costs compared to autonomous divisional policies, and our composite solution method generates near-optimal solutions (within 0.75% of optimality) within reasonable computational time.

Informed Headquarters and Socialistic Internal Capital Markets

This paper develops a theory of resource allocation in internal capital markets that is consistent with the empirical finding that multi-division firms bias their investment levels in favor of divisions with weaker investment prospects. Headquarters has private information about the capital productivities of its divisions; therefore, capital allocations in the present serve as a signal to divisional managers about future allocations. To facilitate effort provision, headquarters biases capital allocation so as to not disclose productivity differences across divisions or to credibly signal their absence. The capital allocation bias is time-varying and the relationship between the bias and the difference in average division productivities is inversely U-shaped.

Two Puzzles about the Diversification Discount: SFAS No. 131 and 'Pseudo-Conglomerates'

I document a large and significant diversification discount in multi-division firms that are diversified neither industrially nor geographically. All divisions of these firms, which are called pseudo-conglomerates, operate in the same finely defined industry. Since divisions of pseudo-conglomerates face similar investment opportunities, the resource allocation problem is less severe and, perhaps, non-existent in these firms. This implies that inefficient internal capital market and diversity across industries play a smaller role in the well-documented conglomerate discount. I also analyze an exogenous event - change in segment-reporting rules from SFAS 14 to SFAS 131 in 1997. I find that standalone firms start trading at a discount when they begin reporting multiple segments after the rule change. This suggests that revealing a more complex structure results in value loss. Together, these results suggest that the diversification discount may be more appropriately called an organizational discount.

Integration, organizational processes, and allocation of resources

Does the level of integration of a firm affect the quality of information available to its top decision makers responsible for allocating resources? Motivated by the pervasiveness of specific knowledge in large multi-division firms, I develop a model of internal competition for corporate resources among specialist managers and show that: (i) managers of integrated firms exaggerate the payoffs of their projects to obtain resources despite potentially adverse career consequences, and (ii) the exaggeration problem worsens with increased integration and reduces the allocative efficiency of an integrated firm. Control rights based on asset ownership enable the firm to set “the rules of the game”and improve managerial behavior through organizational processes such as rigid capital budgets, job rotation, centralization and hierarchies.

Capital Budgeting in Multidivision Firms: Information, Agency, and Incentives

We examine optimal capital allocation and managerial compensation in a firm with two investment projects (divisions) each run by a risk-neutral manager who can provide (i) (unverifiable) information about project quality and (ii) (unverifiable) access to value-enhancing, but privately costly resources. The optimal managerial compensation contract offers greater performance pay and a lower salary when managers report that their project is higher quality. The firm generally underinvests in capital and managers underutilize resources (relative to first-best). We also derive cross-sectional predictions about the sensitivity of investment in one division to the quality of investment opportunities in the other division, and the relative importance of division-level and firm-level performance-based pay in managerial compensation contracts.

Integration, Organizational Processes and Allocation of Resources

Does the level of integration of a firm affect the quality of information available to its top decision makers responsible for allocating resources? Motivated by the pervasiveness of specific knowledge in large multi-division firms, I develop a model of internal competition for corporate resources among specialist managers and show that: (i) managers of integrated firms exaggerate the payoffs of their projects to obtain resources despite potentially adverse career consequences, and (ii) the exaggeration problem worsens with increased integration and reduces the allocative efficiency of an integrated firm. Control rights based on asset ownership enable the firm to set the rules of the game and improve managerial behavior through organizational processes such as rigid capital budgets, job rotation, centralization and hierarchies.

Synergies and Internal Agency Conflicts: The Double-Edged Sword of Mergers

This paper investigates the interaction between synergies and internal agency conflicts that emerges endogenously in multi-division firms. We model internal agency activities as entrenchment: to avoid personal costs, a divisional manager can reduce the likelihood of her division being divested by reducing its attractiveness in an alternative use. As in Williamson (1975, 1985), we characterize asset specificity as the difference between the value of assets in their current use and in alternative uses. We show how the presence of synergies, by modifying this difference, can alter the divisional manager's incentive to entrench herself. While merging divisions is always worthwhile for sufficiently positive synergies, merging firms with mis-deployed assets might actually be detrimental for smaller synergies due to entrenchment incentives spawned by the merger. In mergers of firms with low asset specificity, negative synergies might actually motivate mergers followed by divestiture to improve entrenchment incentives. We emphasize that when the synergy and internal agency effects are of opposite sign, a circumstance we term the double-edged sword of mergers, the gains from merging may not even be increasing in the expected synergies. Finally, in mergers of firms with high asset specificity, synergies alone dictate the choice of organizational form. We characterize when divisions should optimally be stand-alone firms and when they should instead be part of a merged firm. Our model predicts an absence of diversifying mergers in industries plagued by mis-deployed assets and offers a novel explanation for the cross-sectional variation in post-merger valuation. Our model can explain why mergers may be valuable ex ante while leading to successful divestitures ex post, as observed in the 1980s.

Strategic Alliances and the Boundaries of the Firm

Strategic alliances are long-term contracts between legally distinct organizations that provide for sharing the costs and benefits of a mutually beneficial activity. In this paper, I develop and test a model that helps explain why firms sometimes prefer alliances over internally organized projects. I introduce managerial effort into a model of internal capital markets and show how strategic alliances help overcome incentive problems that arise when headquarters cannot pre-commit to particular capital allocations. The model generates a number of implications, which I test using a large sample of alliance transactions in conjunction with Compustat data. Supporting the model, I find that alliances cluster in risky, high-growth, high-tech industries, and that they typically occur between industries with different risk characteristics. Likewise, among multi-division firms with alliances, the alliance activity tends to occur in an industry that is riskier, on average, than the other industries in which the firm operates. Alliances are used to pursue related diversification, and facilitate projects that are riskier than a firm's mainstream activities.

The Benefit and Cost of Winner-Picking: Redistribution versus Incentives

The paper examines the agency cost of winner-picking in multidivision firms and uses explicit incentive contracts to analyze the interactions between corporate headquarters' investment and incentive policies. Winner-picking, i.e. the efficient reallocation of scarce resources in an internal capital market, adds an extra layer of noise to the moral-hazard problem of incentivizing division managers to produce the resources that can then be redistributed. In particular, division managers with strong future investment opportunities anticipate that headquarters will bail them out should they fail to produce enough resources themselves. This reduces incentives to create the resources in the first place, with possible consequences for the optimal investment policy.

Industry Structure and the Conglomerate 'Discount': Theory and Evidence

Recent literature has been largely negative in its assessment of corporate diversification. Diversified firms have been regarded as destructive of firm value, prone to agency problems and divisional rent-seeking. The empirical finding that multi-division firms tend to trade at a 'discount,' or negative 'excess value' relative to their single-segment counterparts, is claimed in support of this view. Our paper offers a different, more positive, perspective. We develop a simple, industry-based model to argue that conglomeration (and discounts) may, in fact, reflect an endogenous, value-enhancing response of firms to industry conditions and agency problems prevalent in all firms, not just conglomerates. With managers reluctant to reduce assets under their control, conglomeration emerges as a way to optimally induce managers to shift resources away from an industry, in response to unfavorable conditions. The model also provides a framework, with testable implications, to analyze patterns of conglomeration and excess values across different environments. The degree of conglomeration in an industry is predicted to have an inverse relation to the excess values of conglomerates in the industry and to the investment opportunities anticipated for single-segment firms. Using a panel data set of fifty of the largest US industries, over 1978-1997, we find significant empirical support for the model's predictions.

Divisional Cost-of-Capital Estimation for Multi-Industry Firms

The research extends work by Fuller and Kerr [11], whose technique requires the identification of at least one publicly traded, single-industry firm to serve as a proxy for a given division. The methodology introduced here incorporates market information on both single-industry and multi-industry firms. This advance is significant for two reasons. First, most large firms operate over a range of industries. As a result, a focus on pure plays ignores a large amount of relevant data. In fact, it may often be impossible to identify a pure play for a particular line of business. Second, as Fuller and Kerr themselves point out, financial leverage considerations may differ between pure-play firms and diversified, multi-division firms. An additional advance of this over prior work on divisional hurdle rates is the use of expectational data from financial analysts. Although finance theory calls for the use of expectational data to estimate required returns, most research has focused on historical realizations as proxies for future expectations. The authors thank the anonymous reviewers for helpful comments.

Divisional Cost of Capital: A Practical Approach

According to one study [3], almost one-half of the industrial firms surveyed there used a single screening rate, such as the cost of capital, to evaluate investment proposals. Another study revealed that the use of a firm's cost of capital as a screening rate could lead to non-optimal decisions if the expected cash flows from the investment are not proportional to those of the firm and have different maturities and growth rates [9]. It follows that a firm's cost of capital may not be the appropriate screening rate to evaluate investment proposals in multi-division firms where the divisions have substantially different degrees of risk and financial characteristics from those of the parent company. Consequently, it is necessary to determine the cost of capital for each division. Divisional cost of capital has been addressed in finance textbooks by Brigham [3] and Van Horne [11], and in the finance literature by Bower and Jenks [1], Fuller and Kerr [4], Gordon and Halpern [5], and others [10, 13]. The studies cited use various derivatives of the capital asset pricing model (CAPM) to estimate the divisional cost of capital. A division is treated as though it were a separate company, and market data, when available, are used to derive the CAPM and the cost of capital. When market data for the division are not available, data from a similar company can be used as a proxy. Other studies dealing with systematic risk and debt capacity [1, 6, 7, 8] are also applicable here because the divisions may not have the same capital structure as their parent companies. This article presents a different approach to determine the divisional cost of capital. The method is based on the one used by Fuqua Industries, Inc., a multi-market manufacturing, distribution, and service company in the areas of recreational products and services, farm and home products, transportation, petroleum, and other operations. Stated otherwise,

Estimating the Divisional Cost of Capital: An Analysis of the Pure‐Play Technique

ABSTRACTThis paper suggests that the pure‐play technique can be used in conjunction with the capital asset pricing model to determine the cost of equity capital for the divisions of a multidivision firm. Since the beta for a division is unobservable in the marketplace, a proxy beta derived from a publicly traded firm whose operations are as similar as possible to the division in question is used as the measure of the division's systematic risk. To provide empirical support for using the pure‐play technique, a sample of multidivision firms and pure‐play associated with each division is examined. It is shown that an appropriately weighted average of the betas of the pure‐play firms closely approximates the beta of the multidivision firm.