Incentives in Internal Capital Markets: Capital Constraints, Competition, and Investment Opportunities

Abstract

This paper considers the effect of competition for scarce financial resources on managers' incentives to generate profitable investment opportunities. Competition is only unambiguously beneficial if projects are symmetric. If divisions differ in their cash endowments or their growth potential, integration may reduce incentives for some managers, which may lower total firm value. Moreover, relaxing capital constraints, e.g., by integrating a cash cow project, may reduce incentives.

We treat two different scenarios where contracts can either only specify monetary incentives or additionally the allocation of funds. While distorted capital allocations increase managers' incentives, they only survive renegotiations in integrated firms.

Keywords: capital allocation, conglomerate discount

JEL Classification: G31, G34, J33