Abstract

We analyze a unique dataset from a survey of CFOs to examine the (micro)foundations of within-firm capital allocation and the workings of internal capital markets. We establish new insights into the profound role of information asymmetries and agency problems in the capital allocation process. Firms largely employ systems of interconnected measures to counteract agency problems, including layers of approval, divisional budgets, reporting requirements, and compensation schemes. We find support for existing theories of capital allocation but the strong emphasis given to bottom-up components in the allocation process by the existing literature may lead to a distorted view of corporate investment: When allocating capital, top management relies heavily on top-level, largely non-financial information, often overriding financial projections and other hard information provided by division management. We also find that internal capital markets are active, implying that capital is reallocated across divisions to improve investment productivity. However, top management admits to frequently tilting capital allocation toward a relatively even distribution, resulting at least in part from the role of capital allocation as a device of credible communication. CFOs have strong opinions about the financing benefits of operating internal capital markets and see their major advantages in lower costs of capital and higher debt capacities.