The Trade-Off Between Ex-Post and Ex-Ante Efficient Capital Allocation in Internal Capital Markets and Organizational Form
30 Pages Posted: 26 Nov 2007
Date Written: January 13, 2007
This paper examines the efficiency of internal capital markets. I develop a model in which headquarters allocates capital ex-post efficiently to the stronger division and find that this can be ex-ante inefficient. Reallocating capital ex-post to the stronger division reduces ex-ante incentives which can only be restored through monetary compensation. This decreases future investment and may result in the internal capital market being sub-optimal compared with two stand-alone divisions. I show how these effects are particularly important for two types of firm. Finally, ex-ante incentives can be restored by an ex-post inefficient social capital allocation rule, which I show to be optimal.
Keywords: capital allocation, internal capital markets, agency
JEL Classification: G31, G34, L22
Suggested Citation: Suggested Citation