Get access

Internal versus External Financing: An Optimal Contracting Approach

Authors

  • Roman Inderst,

    Search for more papers by this author
    • Inderst is at the London School of Economics and Political Science and the CEPR and Müller is at the Leonard N. Stern School of Business, New York University and the CEPR. We are indebted to Patrick Bolton, Rick Green (the editor), and an anonymous referee for helpful comments and suggestions. Thanks also to Yakov Amihud, Ulf Axelson, Mike Burkart, Doug Diamond, James Dow, Zsuzsanna Fluck, Paolo Fulghieri, Martin Hellwig, Owen Lamont, Christian Laux, Anthony Lynch, Alan Morrison, Lasse Pedersen, Per Strömberg, Elu von Thadden, Jeff Wurgler, Jeff Zwiebel, and seminar participants at Berkeley, Chicago, Frankfurt, INSEAD, Lausanne, LSE, Mannheim, NYU, Penn, Princeton, Saarbrücken, Stanford, the Stockholm School of Economics, the European Summer Symposium in Economic Theory (ESSET) in Gerzensee (2000), the European Summer Symposium in Financial Markets (ESSFM) in Gerzensee (2000), and the TMR Meeting on Financial Market Efficiency, Corporate Finance and Regulation in Barcelona (2000) for comments and discussions. Earlier versions of this paper circulated under the titles “Project Bundling, Liquidity Spillovers, and Capital Market Discipline” and “Corporate Borrowing and Financing Constraints.” All errors are our own.

  • Holger M. Müller

    Search for more papers by this author
    • Inderst is at the London School of Economics and Political Science and the CEPR and Müller is at the Leonard N. Stern School of Business, New York University and the CEPR. We are indebted to Patrick Bolton, Rick Green (the editor), and an anonymous referee for helpful comments and suggestions. Thanks also to Yakov Amihud, Ulf Axelson, Mike Burkart, Doug Diamond, James Dow, Zsuzsanna Fluck, Paolo Fulghieri, Martin Hellwig, Owen Lamont, Christian Laux, Anthony Lynch, Alan Morrison, Lasse Pedersen, Per Strömberg, Elu von Thadden, Jeff Wurgler, Jeff Zwiebel, and seminar participants at Berkeley, Chicago, Frankfurt, INSEAD, Lausanne, LSE, Mannheim, NYU, Penn, Princeton, Saarbrücken, Stanford, the Stockholm School of Economics, the European Summer Symposium in Economic Theory (ESSET) in Gerzensee (2000), the European Summer Symposium in Financial Markets (ESSFM) in Gerzensee (2000), and the TMR Meeting on Financial Market Efficiency, Corporate Finance and Regulation in Barcelona (2000) for comments and discussions. Earlier versions of this paper circulated under the titles “Project Bundling, Liquidity Spillovers, and Capital Market Discipline” and “Corporate Borrowing and Financing Constraints.” All errors are our own.


Abstract

We study optimal financial contracting for centralized and decentralized firms. Under centralized contracting, headquarters raises funds on behalf of multiple projects. Under decentralized contracting, each project raises funds separately on the external capital market. The benefit of centralization is that headquarters can use excess liquidity from high cash-flow projects to buy continuation rights for low cash-flow projects. The cost is that headquarters may pool cash flows from several projects and self-finance follow-up investments without having to return to the capital market. Absent any capital market discipline, it is more difficult to force headquarters to make repayments, which tightens financing constraints ex ante. Cross-sectionally, our model implies that conglomerates should have a lower average productivity than stand-alone firms.

Get access to the full text of this article

Ancillary