Internal Capital Markets And Corporate Refocusing
John G. Matsusaka
University of Southern California - Marshall School of Business; USC Gould School of Law
Vikram K. Nanda
Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick
USC Finance & Business Econ. Working Paper No. 01-6
This paper develops a theory of organization based on the benefits and costs of internal capital markets. A central assumption is that the transaction cost of raising external funds is greater than the cost of internal funds. The benefit of internal resource allocation is that it gives the firm a real option to avoid external capital markets (and the associated deadweight transaction costs) in more states of the world than single-business firms. The cost is the internal resource flexibility exacerbates an over investment agency problem. The optimal focus is determined by trading off the benefit of the option against the cost of over investment. In this context, we show how the relative efficiency of integration and separation depends ultimately on assignment of control rights over cash flow. Testable implications are derived for the level of divisional investment, the sensitivity of divisional investment to cash flow, and the diversification discount.
Number of Pages in PDF File: 53
JEL Classification: G30
Date posted: October 17, 2001
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