Resource Allocation in Conglomerates Under Moral Hazard

50 Pages Posted: 15 Dec 2000

See all articles by Anand M. Goel

Anand M. Goel

Stevens Institute of Technology

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

M. P. Narayanan

University of Michigan, Stephen M. Ross School of Business

Date Written: August 2000

Abstract

This paper investigates the resource allocation decision in conglomerates under moral hazard. We consider a firm where the input factors are unknown managerial ability that is common to all divisions, capital allocated to each division, and intangible resources that the manager allocates to each division. While capital allocation across divisions is fully observable, the allocation of intangible resources is only partially observable. The divisions differ in how informative of their cash flows are about managerial ability. The manager maximizes perceived ability. In this set up, we show that divisions with more informative cash flows about the manager's ability receive more than the first-best allocation of both capital and intangible resources. This allocation inefficiency results in conglomerates being valued less than a portfolio of single-segment firms. The paper shows that the diversification discount increases with the variance of informativeness, and the correlation, between the divisions. The discount decreases as the observability of the intangible resource allocation improves. The model also highlights a cost of segment reporting, namely, that it creates avenues for managers to distort their perceived ability at the expense of shareholders.

Suggested Citation

Goel, Anand Mohan and Nanda, Vikram K. and Narayanan, M. P., Resource Allocation in Conglomerates Under Moral Hazard (August 2000). AFA 2001 New Orleans. Available at SSRN: https://ssrn.com/abstract=249977 or http://dx.doi.org/10.2139/ssrn.249977

Anand Mohan Goel (Contact Author)

Stevens Institute of Technology ( email )

Hoboken, NJ 07030
United States

HOME PAGE: http://www.anandgoel.org

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

M. P. Narayanan

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-763-5936 (Phone)
734-936-0274 (Fax)

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