A Theory of Socialistic Internal Capital Markets

Antonio E Bernardo, Jiang Luo and James J.D. Wang

University of California at Los Angeles, Anderson Graduate School of Management from Anderson Graduate School of Management, UCLA

Abstract: We develop a model of a two-division firm in which the “strong” division has,on average, higher quality investment projects than the “weak” division. We show that the firm optimally biases its project selection policy in favor of the weak division and this bias is stronger when there is a greater spread in average project quality. The cost of such a policy is that the firm sometimes funds an inferior project but the benefit is that it motivates the manager of the strong division to set (and meet) more aggressive cash flow targets.

Date: 2005-03-04
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