Incentives in Internal Capital Markets

Roman Inderst and Christian Laux

No 00-47, Sonderforschungsbereich 504 Publications from Sonderforschungsbereich 504, Universität Mannheim, Sonderforschungsbereich 504, University of Mannheim

Abstract: The present paper analyzes the effect of competition for scarce corporate financial resources on managers' incentives to generate profitable investment opportunities. Competition is only unambiguously beneficial if projects are symmetric. If they are asymmetric, competition for corporate financial resources may reduce incentives. This finding may provide a rationale for the diversification discount that is distinct from the explanations based on an inefficient allocation of corporate financial resources. Contracting on the allocation of funds may increase the investment allocation's sensitivity to the quality of investment opportunities and overcome some of the problems when projects are asymmetric. Hence, distorted capital allocation in an internal capital market may serve the purpose of increasing managers' incentives. Finally, we show that profits may decrease if a cash cow project is integrated into an existing internal capital market as this reduces competition. Based on this finding we argue that creating financial constraints may be an optimal response to managerial incentive problems.

Pages: 35 pages
Date: 2000-10-18
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Citations: View citations in EconPapers (10)

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