The Economics of Capital Allocation in Firms: Evidence from Internal Capital Markets

Abstract

We analyze a unique survey dataset to examine the (micro)foundations of capital allocation in firms. Firms employ systems of interconnected measures to counteract agency problems, including layers of approval, divisional budgets, reporting requirements, and compensation schemes. When making funding decisions, top management relies heavily on top-level, non-financial information. However, substantial parts of the capital budget do not require top management approval as firms trade off the benefits and costs of decentralization. Even firms with active internal capital markets tilt capital allocation toward relatively even distributions. Within-firm agency problems may result in divisions’ restricted access to internal capital.

Keywords: Capital Budgeting, Internal Capital Markets, Agency, Information Asymmetry, Corporate Investment

JEL Classification: G30, G31, G32, M40, M41, M20, M21