A Theory of Socialistic Internal Capital Markets
Antonio E. Bernardo
University of California, Los Angeles (UCLA) - Finance Area
Hong Kong University of Science & Technology (HKUST) - Department of Finance
James J. D. Wang
City University of Hong Kong (CityUHK) - Department of Economics & Finance
January 21, 2005
AFA 2006 Boston Meetings Paper
We develop a model of a two-division firm in which the strong division has, on average, higher quality investment projects than the weak division. We show that the firm optimally biases its project selection policy in favor of the weak division and this bias is stronger when there is a greater spread in average project quality. The cost of such a policy is that the firm sometimes funds an inferior project but the benefit is that it motivates the manager of the strong division to set (and meet) more aggressive cash flow targets.
Number of Pages in PDF File: 39
Keywords: Internal capital markets, conglomerates, project selection
JEL Classification: G31
Date posted: March 25, 2005
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