The Impact of Stock Market Information Production on Internal Resource Allocation

Abstract

In this paper we analyze the resource allocation decision of a manager of a multi division firm whose compensation is based on the firms stock price. We find that internal investments exhibit a positive correlation across the firms divisions. In particular, when two divisions are put into one firm the optimal investment level in one division becomes more positively related to the investment level in the other division. This is relative to the situation in which the two divisions trade as two separate firms. As a consequence, following a spinoff divisional investments go down whenever the spun off division has a project with a (relatively) low Sharpe ratio and go up whenever the division has a project with a (relatively) high Sharpe ratio. Relating investment choice to firm value we show that multi division firms trade at a discount relative to single division firms and that the discount is larger when the investment sets of the two divisions are more diverse.

JEL Classification: G00, G30, G31, L22