Incentives in Internal Capital Markets: Capital Constraints, Competition, and Investment Opportunities

We examine the effect of competition for scarce corporate financial resources on managers' incentives to generate profitable investment opportunities. Operating an active internal capital market is unambiguously beneficial only if divisions have the same level of financial resources and the same investment potential. Otherwise, managers' incentives may be lower and an internal capital market may decrease firm value even though headquarters allocates capital efficiently. We analyze under which conditions the operation of an internal capital market is more likely to add value, and we derive implications for the boundaries of firms, for a potential conglomerate discount or premium, and for the role of incentive pay for division managers.

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