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

57 Pages Posted: 30 Oct 2017 Last revised: 5 Nov 2017

Daniel Hoang

Karlsruhe Institute of Technology (KIT)

Sebastian Gatzer

Karlsruhe Institute of Technology (KIT)

Martin E. Ruckes

Karlsruhe Institute of Technology

Date Written: October 26, 2017

Abstract

We analyze a unique dataset from a survey of CFOs to examine the (micro)foundations of within-firm capital allocation and the workings of internal capital markets. We establish new insights into the profound role of information asymmetries and agency problems in the capital allocation process. Firms largely employ systems of interconnected measures to counteract agency problems, including layers of approval, divisional budgets, reporting requirements, and compensation schemes. We find support for existing theories of capital allocation but the strong emphasis given to bottom-up components in the allocation process by the existing literature may lead to a distorted view of corporate investment: When allocating capital, top management relies heavily on top-level, largely non-financial information, often overriding financial projections and other hard information provided by division management. We also find that internal capital markets are active, implying that capital is reallocated across divisions to improve investment productivity. However, top management admits to frequently tilting capital allocation toward a relatively even distribution, resulting at least in part from the role of capital allocation as a device of credible communication. CFOs have strong opinions about the financing benefits of operating internal capital markets and see their major advantages in lower costs of capital and higher debt capacities.

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

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

Suggested Citation

Hoang, Daniel and Gatzer, Sebastian and Ruckes, Martin E., The Economics of Capital Allocation in Firms: Evidence from Internal Capital Markets (October 26, 2017). Available at SSRN: https://ssrn.com/abstract=3059620

Daniel Hoang (Contact Author)

Karlsruhe Institute of Technology (KIT) ( email )

Karlsruhe
Germany

Sebastian Gatzer

Karlsruhe Institute of Technology (KIT) ( email )

Kaiserstraße 12
Karlsruhe, Baden Württemberg 76131
Germany

Martin Ruckes

Karlsruhe Institute of Technology ( email )

Kaiserstraße 12
Karlsruhe, Baden Württemberg 76131
Germany

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