This study examines whether multidivisional firms’ internal capital markets allocate equity issue proceeds efficiently and whether they supply sufficient capital to businesses that typically issue equity actively. Multidivisional firms do not issue equity as often as stand-alone firms do, and their propensity to issue equity declines with the number of their segments (a proxy for coinsurance). The primary destination of equity issue proceeds appears to be core or large segments, but not necessarily high-Q segments. Equity issue proceeds flow relatively little to segments that run “equity-dependent business”—defined as the type of business that will use equity issuance intensely if it is run by a stand-alone firm. As a result, equity-dependent business within multidivisional firms is underinvested relative to stand-alone firms or other segments. A significant portion of the “conglomerate discount” can be attributed to the extent of multidivisional firms’ equity-dependent business. Taken together, there is little evidence that internal capital markets allocate equity issue proceeds efficiently. Internal capital markets fail to provide adequate financial support to equity-dependent business—e.g., businesses characterized by high market-to-book, fast growth and uncertainty—resulting in a loss of value.
Key words: Internal capital market, equity issuance, diversification discount, conglomerate, corporate investment
JEL classification: G31, G32, G20
