The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment

Abstract

We develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division mangers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of "socialism" in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.MIT Sloan School of Management and NBER. This paper is a completely overhauled version of our March 1997 NBER working paper (#5969) with the same title. We have received research support from the National Science Foundation and the Finance Research Center at MIT. We are grateful to

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