Mis-allocation within firms: internal finance and international trade

BIS Working Papers  |  No 1030  | 
14 July 2022



Are conglomerate firms highly productive? Or do they suffer from internal quarrels and squander investment opportunities? An established observation in the trade literature is that conglomerate firms are more productive than single-product firms. By contrast, the finance literature has established that multi-segment firms trade at a discount to single-product firms, with a lower valuation ("Tobin's Q"), because funds are misallocated across their divisions through the internal capital market.


Reconciling these two conflicting views, we develop a novel theory of misallocation within firms due to managerial empire-building. We introduce an internal capital market into a two-factor model of multi-segment firms. The combination of these features lets us investigate the interplay between internal capital markets and international competition, thus opening up the black box of multi-product firms for a closer inspection.


First, we find that informational frictions between headquarters and divisional managers can lead to the over-reporting of divisions' costs, resulting in an inefficient allocation of capital across a firm's divisions. This misallocation results in the conglomerate discount, ie a situation in which the market values a diversified firm at less than the sum of its parts. Second, our model shows that international trade reduces capital misallocation through competition. Tougher competition lowers the cost level at which firms and their divisions can survive in the market and reduces managers' scope for misreporting. By reducing capital misallocation within firms, this shrinks the conglomerate discount. We test our model's key predictions with data on US companies and find strong support. Our findings imply that more market competition can go a long way towards curbing division managers' empire-building behaviour, because it intensifies pressure on headquarters to allocate funds toward the most efficient projects.


This paper develops a novel theory of capital mis-allocation within firms that stems from managers' empire building and informational frictions within the organization. Introducing an internal capital market into a two-factor model of multi-segment firms, we show that competition imposes discipline on managers and reduces capital mis-allocation across divisions, thereby lowering the conglomerate discount. The theory can explain why exporters exhibit a lower conglomerate discount than non-exporters (a new fact we establish). We then exploit the China shock as an exogenous shock to competition to test the model's predictions with data on US companies. Results show that tougher competition significantly reduces managers' over-reporting of costs and improves the allocation of capital within firms.

JEL classification: F12, G30, L22, D23. 

Keywords: multi-product firms, trade and organisation, internal capital markets, conglomerate discount, China shock.