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

  • Author(s): David S. Scharfstein, Jeremy C. Stein
  • Published: Dec 17, 2002
  • Pages: 2537-2564
  • DOI: 10.1111/0022-1082.00299

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 managers 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.

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