Information Asymmetry, Budget Constraints, and Efficiency and Profitability of Internal Capital Markets

Abstract

This paper is inspired by three empirical findings: (i) Conglomerates are traded at an average discount; (ii) Plants in conglomerates are more productive than plants in comparable single-segment firms; (iii) Employees in conglomerates are paid higher. The paper develops a model demonstrating that the internal capital markets of conglomerates can ease budget constraints but at the same time provide project managers with more incentives to manipulate investment information. Because they have to pay higher information rents to managers, conglomerates are likely to be less profitable than comparable single-segment firms although they are more efficient in resource allocation.

Keywords: Internal capital market, conglomerate, efficient resource allocation, profitability

JEL Classification: G30, G32