Incentives and Information in Internal Capital Markets

This paper presents a model of capital budgeting of a multi-dimensional firm in the presence of both asymmetric information and moral hazard. We demonstrate that it depends on the cost of effort whether the capital allocation to a given division decreases in project quality more or less rapidly than optimal to induce the manager’s private information. We first show that, absent moral hazard, it requires an inefficient manager to be capital-rationed. However, this internal capital rationing decrease if moral hazard is introduced in the model. In particular, the headquarters should provide more capital for an inefficient division than socially efficient if the manager’s effort aversion is sufficiently low. The result is consistent with empirical findings that inefficient divisions may be overinvested.