Cross Subsidies, External Financing Constraints, and the Contribution of the Internal Capital Market to Firm Value

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Abstract
This paper examines the link between the value of a diversified firm and the value of its internal capital. We construct measures of the value of internal capital market transactions based on the dollar flow of subsidies and transfers across segments, the relative investment opportunities of segments, and the likelihood that a segment receiving a subsidy would face external financing constraints if it were a stand-alone firm. We find that specific components of a diversified firm's internal capital market are important determinants of its excess value. Subsidies to small financially constrained segments with good relative investment opportunities significantly increase excess value, while transfers of resources from segments with good relative investment opportunities significantly decrease excess value. Surprisingly, subsidies to small financially constrained segments with poor relative investment opportunities also significantly increase excess value, albeit to a lesser extent than the subsidies to constrained segments with good relative investment opportunities. We conclude that financing constraints drive the relationship between the internal capital market and firm value.

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