Adoptions and Eliminations of Economic Profit Plans and Internal Capital Markets Efficiency

Abstract

Internal capital markets of diversified firms have been associated with inefficient allocation of investment funds across divisions, leading to value losses. Utilizing a sample of diversified firms that adopted or eliminated Economic Profit Plans (EPPs) between 1990 and 2009, we show that adoptions of those plans (that reward profitability, but penalize excessive capital investment) mitigate investment distortions and lead to value gains. Following the adoption of EPPs, diversified firms start allocating investment funds based on growth opportunities of their divisions. EPP adopters lower their divisional investment levels, especially in segments with below-average growth opportunities. The overall investment allocation efficiency improves, and the diversification discount diminishes after the adoption of EPPs. However, EPPs appear to be used only as temporary tools for assessing corporate performance. The plans are adopted primarily by firms expected to immediately generate plan bonuses for management, and they are frequently eliminated by firms with bad accounting performance, and low managerial bonuses. The study contributes to the literature on organizational efficiency, internal capital markets and on the importance of measures based on economic profits or residual income.

Keywords: internal capital markets, economic profit plans, diversification, investment efficiency

JEL Classification: G32, G34