Divisional Managers and Internal Capital Markets

The following post comes to us from Ran Duchin of the Department of Finance at the University of Washington and Denis Sosyura of the Department of Finance at the University of Michigan.

In our paper, Divisional Managers and Internal Capital Markets, forthcoming in the Journal of Finance, we study the role of divisional managers in internal capital budgeting.

While the capital budgeting process is one of the most fundamental corporate decisions, introduced at the very beginning of virtually any finance textbook, we still know relatively little about this area of the inner workings of a firm. Our paper seeks to advance our knowledge of this corporate decision by studying the role of human capital in a firm’s capital budgeting and the involvement of managers at various levels of hierarchy. In particular, we construct a hand-collected dataset of divisional managers at the S&P 500 firms and examine the effect of managerial influence on investment decisions and firm value. We study managerial influence via both formal channels (e.g., managers’ board membership and seniority), and informal channels (e.g., managers’ social connections to the CEO via prior employment, education, and nonprofit organizations).

We find that managers with social connections to the CEO are allocated significantly more capital, controlling for divisions’ size, performance, proxies of investment opportunities, proxies of managerial ability, and other characteristics. A divisional manager with a social connection to the CEO is allocated 9.2 percent more capital or approximately $5.3 million in additional annual capital expenditure. In contrast to the significant effect of managers’ informal connections to the CEO, connections to the CFO and the board have only a weak positive effect, and proxies of managers’ formal influence have no significant effect.

We identify two primary channels through which connected divisional managers receive extra capital: (1) appointment to capital-rich divisions (the appointment channel) and (2) extra capital allocations after the appointment (the capital allocation channel). To disentangle the capital allocation channel from the appointment channel, we exploit the shock to managerial connections at the time of the CEO turnover. This approach allows us to capture the amount of extra capital allocated to divisional managers after their connections to the CEO change, but their appointment at the division remains constant. It also enables us to control for all time-invariant characteristics of the divisional manager and his or her division. Our estimates indicate that the effect of the capital allocation channel is about twice as large as that of the appointment channel.

Next, we study the effect of managerial influence on investment efficiency and firm value. On the one hand, greater capital allocations to connected managers may be indicative of favoritism, serving as a value-destroying channel for personal favors from the CEO.  Alternatively, social connections between the CEO and divisional managers may increase the trust between these agents and improve the quality of information about divisions’ investment opportunities, thus increasing firm value.

We find that at firms with weaker governance, social connections between divisional managers and the CEO are associated with lower investment efficiency and lower firm value, consistent with the favoritism view. In contrast, at firms with high information asymmetry, social connections between divisional managers and the CEO are positively related to investment efficiency and firm value, consistent with the information view. In sum, the effect on managerial connections on firm value depends on the balance between governance quality and information asymmetry.

Overall, our article demonstrates the importance of intra-firm governance in corporate investment decisions and identifies the mechanisms through which managers outside the executive suite influence firm value.

The full paper is available for download here.

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