We develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division mangers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra com- pensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of "socialism" in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.

We model the distortions that internal power struggles can generate in the allocation of resources between divisions of a diversified firm. The model predicts that if divisions are similar in the level of their resources and opportunities, funds will be transferred from divisions with poor opportunities to divisions with good opportunities. When diversity in resources and opportunities increases, however, resources can flow toward the most inefficient division, leading to more inefficient investment and less valuable firms. We test these predictions on a panel of diversified U.S. firms during the period from 1980 to 1993 and find evidence consistent with them. THE FUNDAMENTAL QUESTION IN THE THEORY of the firm, raised by Coase ~1937! more than 60 years ago, is how decisions taken inside a hierarchy differ from those taken in the marketplace. Coase suggested that decisions within a hierarchy are determined by power considerations rather than relative prices. If this is indeed the case, why, and when, does the hierarchy dominate

This article designs a framework for evaluating the causes, consequences, and future implications of financial services industry consolidation, reviews the extant research literature within the context of this framework (over 250 references), and suggests fruitful avenues for future research. The evidence is consistent with increases in market power from some types of consolidation; improvements in profit efficiency and diversification of risks, but little or no cost efficiency improvements on average; relatively little effect on the availability of services to small customers; potential improvements in payments system efficiency; and potential costs on the financial system from increasing systemic risk or expanding the financial safety net. JEL classification codes: G21, G28, G34, E58, L89 Key words: Banks, Mergers, Payments, Small business The opinions expressed do not necessarily reflect those of the Federal Reserve Board, the New York Reserve Bank, or their staffs. We thank Bob ...

Agency Problems, Equity Ownership, and Corporate Diversification We provide evidence on the agency cost explanation for corporate diversification by documenting three principal findings. First, there is a strong negative relation between the extent of diversification and managerial equity ownership after controlling for other factors related to diversification. Second, there is a weak negative relation between the value loss from diversification and managerial ownership. Third, decreases in diversification are associated with external corporate control threats, financial distress, and management turnover. These findings are consistent with the hypotheses that agency problems are responsible for firms maintaining value-reducing diversification strategies and that the recent trend towards increased corporate focus is attributable to market disciplinary forces. 3 Agency Problems, Equity Ownership, and Corporate Diversification Several recent studies examine the valuation consequences ...

We develop a profit-maximizing neoclassical model of optimal firm size and growth across different industries based on differences in industry fundamentals and firm productivity. In the model, a conglomerate discount is consistent with profit maximization. The model predicts how conglomerate firms will allocate resources across divisions over the business cycle and how their responses to industry shocks will differ from those of single-segment firms. Using plant level data, we find that growth and investment of conglomerate and single-segment firms is related to fundamental industry factors and individual segment level productivity. The majority of conglomerate firms exhibit growth across industry segments that is consistent with optimal behavior. SEVERAL RECENT ACADEMIC PAPERS and the business press claim that conglomerate firms destroy value and do a poor job of investing across business segments. 1 Explanations for this underperformance share the idea that there is an imperfection either in firm governance ~agency theory! or in financial markets ~incorrect valuation of firm industry segments!. These studies implicitly assume that the conglomerates and single-industry firms possess similar ability to compete, and that they differ mainly in that conglomerates

Motivated by the behavior of asset prices, trading volume and price volatility during historical episodes of asset price bubbles, we present a continuous time equilibrium model where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset owner has an option to sell the asset to other overconfident agents when they have more optimistic beliefs. As in Harrison and Kreps (1978), this re-sale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. Agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, large bubbles are accompanied by large trading volume and high price volatility. Our model has an explicit solution, which allows for several comparative statics exercises. Our analysis shows that while Tobin’s tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility. We also give an example where the price of a subsidiary is larger than its parent firm. This paper was previously circulated under the title “Overconfidence, Short-Sale Constraints and Bubbles.”

I examine whether the discount of diversified firms can actually be attributed to diversification itself, using recent econometric developments about causal inference. The value effect of diversification is unbiasedly estimated by matching diversified and specialized firms on the propensity score----the predicted values from a probit model of the propensity to diversify. I apply this method on a sample of diversified firms that trade at a significant mean and median discount relative to specialized firms of similar size and industry. I find that, when a more comparable benchmark based on propensity scores is used, the diversification discount as such disappears or even turns into a premium. 1 In a seminal paper, Wernerfelt and Montgomery (1988) find that diversification has a negative effect on firm value, as measured by Tobin's q. Their result has been confirmed by the later studies of Lang and Stulz (1994), Berger and Ofek (1995), and others who, using an industry-adjusted Tobin's ...

This paper argues that the documented discount on diversified firms is not per se evidence that diversification destroys value. Firms choose to diversify. We use three alternative econometric techniques to control for the endogeneity of the diversification decision, and find evidence supporting the self-selection of diversifying firms. We find a strong negative correlation between a firm's choice to diversify and firm value. The diversification discount always drops, and sometimes turns into a premium. There also exists evidence of self-selection by refocusing firms. These results point to the importance of explicitly modelling the endogeneity of the diversification status in analyzing its effect on firm value.

The valuation effect of diversification is examined for large samples of firms in

Does CEO overconfidence help to explain merger decisions? Overconfident CEOs overestimate their ability to generate returns. As a result, they overpay for target companies and undertake value-destroying mergers. The effects are strongest if they have access to internal financing. We test these predictions using two proxies for overconfidence: CEOs' personal overinvestment in their company and their press portrayal. We find that the odds of making an acquisition are 65 % higher if the CEO is classified as overconfident. The effect is largest if the merger is diversifying and does not require external financing. The market reaction at merger announcement (–90 basis points) is significantly more negative than for non-overconfident CEOs (–12 basis points). We consider alternative interpretations including inside information, signaling, and risk tolerance.