Managerial Incentives and Internal Capital Markets

Authors

  • Adolfo de Motta

    Search for more papers by this author
    • de Motta is from the Faculty of Management at McGill University. I would like to thank Denis Gromb, Bengt Holmstrom, and Sendhil Mullainathan for their advice, as well as Alberto Abadie, Andres Almazan, Fernando Aportela, Adam Ashcraft, Susan Athey, Sanjay Banerji, Susan Christoffersen, Jan Ericsson, Tomomi Kumagai, Robert Marquez, Jaime Ortega, Gordon Phillips, Antoine Renucci, David Scharfstein, Omar Toulan, and seminar participants at Instituto de Empresa, ITAM, McGill University, Stockholm School of Economics, Universidad Carlos III, University of Amsterdam, University of Illinois, University of Maryland, and participants at the MIT Theory Lunch and MIT Finance Lunch for their comments. I am also grateful to Rick Green (editor) and an anonymous referee for detailed comments. Financial support was provided by the Bank of Spain.

Abstract

Capital budgeting in multidivisional firms depends on the external assessment of the whole firm, as well as on headquarters' assessment of the divisions. While corporate headquarters may create value by directly monitoring divisions, the external assessment of the firm is a public good for division managers who, consequently, are tempted to free ride. As the number of divisions increases, the free-rider problem is aggravated, and internal capital markets substitute for external capital markets in the provision of managerial incentives. The analysis relates the value of diversification to characteristics of the firm, the industry, and the capital market.

Ancillary