Working Paper: CEPR ID: DP2784
Authors: Roman Inderst; Holger M. Müller
Abstract: This Paper adopts an optimal contracting approach to internal capital markets. We study the role of headquarters in contracting with outside investors, with a focus on whether headquarters eases or amplifies financing constraints compared to decentralized firms where individual project managers borrow separately. If projects differ in their ex post cash-flows, headquarters makes greater repayments to investors than decentralized firms, which eases financing constraints. Effectively, headquarters then subsidizes low-return projects with high-return projects' cash. On the other hand, headquarters may, by pooling cash flows and accumulating internal funds, make investments without having to return to the capital market. Without any capital market discipline, however, it is harder for outside investors to force the firm to disgorge funds, which tightens financing constraints ex ante. Both the costs and benefits of internal capital markets are endogenous and arise as part of an optimal financial contract. Our results are consistent with empirical findings showing that conglomerate firms trade at a discount relative to a comparable portfolio of stand-alone firms.
Keywords: Diversification discount; Internal capital markets; Theory of the firm
JEL Codes: D32; G31; G32; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| centralized borrowing (H74) | alleviation of financing constraints (G32) |
| centralized borrowing (H74) | effective management of cash flows (G32) |
| centralized control (H77) | better debt repayment outcomes (G51) |
| centralized borrowing (H74) | withdrawal of funds from individual projects (G35) |
| lack of control (D10) | tighter credit constraints (E51) |
| centralized structures (L22) | tightening of financing constraints (F65) |