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Executive Compensation and Internal Capital Market Efficiency

Optimal allocation of scarce resources is at the heart of wealth creation in a free market economy. Efficient external capital markets facilitate in this process by allocating capital to the most productive investments. Similarly, efficiency of the internal capital market is critical to value creation in a multi-segment firm.

Allocation of internal capital rests at the discretion of top managers who are expected to channel funds to segments with the highest value-added projects. Therefore, the value created from investments in a multi segment firm critically hinges on how effectively internal capital is allocated among various divisions by the top managers at the corporate headquarters.

These managers have control rights that allow them the discretion of "winner-picking" when it comes to allocating capital between divisions. The ability to allocate corporate resources also presents the top executives at the headquarters (we designate the chief executive officer (CEO) to represent this group) with the opportunity to extract private benefits at the cost of mis allocating corporate resources leading to value destruction for the shareholders of multi-segment firms.

This study examines the link between CEO incentive compensation and the efficiency of internal capital markets. Studying this linkage will contribute to the internal capital markets literature by shedding light on the importance of CEO compensation structure in internal capital allocation efficiency.

Executive Compensation and Internal Capital Market Efficiency