Does Internal Capital Market Membership Matter for Capital Allocation? Theory and Evidence from the Euro Area

Abstract

This paper investigates the capital allocative behavior of firms' integrating active internal capital markets (ICM). Specifically, examines the investment-cash flow sensitivity and its relationship with factors, such as, financial flexibility, suboptimality of investment expenditure, and crosssubsidization, using a matched sample design of two comparable panel data sets of 636 subsidiaries and stand-alone firms of the euro area, over the 2004-2013 sampling period. Results from panel data regression document that ICM firms exhibit lower sensitivity to the availability of internal funding than pure-play stand-alone firms, and that for stand-alone firms the effect of financial flexibility on investment-cash flow sensitivity is larger than for ICM cohorts. Findings also document that, on average, subsidiaries experience lower levels of investment suboptimality, and that subsidiaries with poor growth opportunities, ceteris paribus, invest less than pure-play stand-alone firms, consistent with lower cross-subsidization problems within ICMs. These findings are consistent with the propositions that centralized capital budgeting systems can potentially mitigate informational and incentive problems associated with investment behavior, and that subsidiary firms may use internal capital markets as a substitute for financial slack.