A q$q$ Theory of Internal Capital Markets

Abstract

ABSTRACTWe propose a tractable model of dynamic investment, spinoffs, financing, and risk management for a multidivision firm facing costly external finance. Our analysis formalizes the following insights: (i) Within‐firm resource allocation is based not only on divisions' productivity, as in winner‐picking models, but also their risk; (ii) firms may voluntarily spin off productive divisions to increase liquidity; (iii) diversification can reduce firm value in low‐liquidity states, as it increases the spinoff cost and hampers liquidity management; (iv) corporate socialism makes liquidity less valuable; and (v) division investment is determined by the ratio between marginal and marginal value of cash.