The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment

Abstract

We develop a model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. In an effort to stop rent-seeking, corporate headquarters will be effectively forced into paying bribes to some division managers. And because headquarters is itself an agent of outside investors, the bribes may take the form not of cash, but rather of preferential capital budgeting allocations. One interesting feature of our model is a kind of socialism' in internal capital allocation, whereby weaker divisions tend to get subsidized by stronger ones.