Do divisions or business units in large conglomerates with better investment opportunities receive larger capital expenditure budgets and thus invest more? Or is it possible that they receive higher budgets simply because they are run by more powerful and not necessarily better managers? This is the question we tackle in this paper empirically. Common sense suggests that managers who are powerful inside organizations are more successful in pursuing their personal goals and in receiving larger allocations of capital for their own units. This idea has also been formalized in models by Meyer, Milgrom and Roberts (1992), Scharfstein and Stein (2000), Rajan, Servaes and Zingales (2000) or Wulf (2008). These models assume that Division CEOs inside firms have a preference for larger capital allocations (for rent-seeking/empire building reasons) and therefore conduct activities to get more funds allocated (so-called influence activities). These influence activities cause costs because of the resources spent on affecting allocations and because of the resulting suboptimal investment decisions. In general, these internal capital market models predict that managers with more bargaining power vis-a-vis the CEO of the firm are more likely to get larger capital allocations.
We argue that the situation in the empirical literature on internal capital markets is similar to the one on internal labor markets where Baker and Holmstrom (1995) argued that there are “too many theories, too few facts” and “we need ... additional studies of personnel records, supplemented by interviews and institutional facts.” Following their argumentation, Baker, Gibbs and Holmstrom (1994a, 1994b) tested theories based on detailed internal labor market data from a single firm. Motivated by this approach, we study what happens in the internal capital market of a large international conglomerate that operates worldwide and is headquartered in Europe. More specifically, we look at the effects of bargaining power on the allocation of capital for investment (capital expenditure). We use a proprietary, very rich and detailed data set on realized and planned capital allocations. The data set is based on internal management accounting data and allows us to precisely look inside the conglomerate to test our predictions. Our data contains detailed information on all five divisions of the firm as well as on all 22 business units. The business units operate under the roof of the divisions which have no operating activities themselves. We have monthly realized (actual) allocation data for the period 01/2001-12/2006 and quarterly planned allocation data for the period 01/2002-12/2006.
We measure the bargaining power of Division CEOs (which are governing the business units) in three complementary ways that capture different aspects of power. First, we follow the empirical corporate governance literature and look at the tenure of the Division CEOs. We follow papers such as Ryan and Wiggins (2004) or Berger, Ofek and Yermack (1997) and assume that the power of a Division CEO increases as his tenure lengthens. Tenure hereby tries to captures the influence and social networks of a specific person inside the company. We also construct a related tenure variable by measuring instead of the tenure inside the firm the number of months in the Division CEO position. Second, we measure the type of academic degree a Division CEO holds. More specifically, we argue that a Division CEOs with an engineering degree can be regarded as more powerful inside our firm for a set of reasons. Our sample firm has a very strong and very long engineering tradition. All past CEOs were engineers, the firm has patents on some of the most important engineering innovations in modern history, and an engineering background matters a lot for a company career according to statements by several people of the firm. Third, we measure whether Division CEOs have the nationality of the country where the firm originates from, and where the headquarters and its main operations are. We hereby try to measure power from a socio-cultural perspective and assume that Division CEOs that have the local nationality are more powerful inside the organization.
We first study whether ex ante capital allocations are efficient in the sense that business units with higher expected investment opportunities receive larger capital allocations, independent of the bargaining power of their respective Division CEOs. Our results show that bargaining power does not distort ex ante allocations of capital in the institutionalized allocation process of the firm. This result suggests that the process of setting ex ante capital allocation plans is designed in a way that eliminates inefficient influence activities. This finding is consistent with the fact that our description of the firm’s capital allocation process shows that the conglomerate uses sophisticated and institutionalized procedures which closely match the textbook recommendations for capital allocation processes (see Anthony and Govindarajan (2003) or Brealey, Myers and Allen (2006)). We also show that the ex ante planned values (e.g., for capital expenditures) are, on average, higher than the ex post realized ones. This phenomenon is called “budgetary slack” and has been documented in the management accounting literature (see, example, e.g., Davila and Wouters (2005) and the references cited therein).
We then use a methodology that is similar to the one employed in Blanchard, Lopez-de-Silanes and Shleifer (1994) and study whether the within-firm distribution of eight unexpected and largely exogenous cash windfalls at the headquarters level is affected by power. The cash windfalls result from the sale of equity participations in other firms and are not included in the ex ante allocation plans. However, once occurred, the capital from these windfalls is partially available for the investment of the business units and can cause a deviation between planned and realized capital allocations.
We show that Division CEOs with more bargaining power get larger parts of the cash windfalls for investment by their own business units. This finding is consistent with a managerial power story. We document that the economic effects of power on the distribution of the cash windfalls is large. We show that the cash windfalls increase the quarterly investment rate (capital expenditures/total assets) of an average business unit from 0.0089 to 0.0136, which is an increase in investment by 53%. This change in investment is significantly larger for business units of more powerful Division CEOs. If power is, for example, measured by tenure in the firm, then the change in investment is 0.0130 larger for more powerful Division CEOs. This difference in investment is equivalent to 146% of the average investment rate of all business unit quarters without cash windfalls.
We then measure how investment changes relative to what has initially been planned by the firm. We find that cash windfalls have the effect of bringing realized investment rates closer to the initially planned ones. The cash windfall induced change is again economically significant: in an average quarter without a windfall, realized investment lies 0.0057 below planned investment. This difference reduces to only 0.0020 in an average cash windfall quarter. We then show that the cash windfall induced change in investment is again significantly stronger for business units governed by more powerful Division CEOs. Again, the economic effects are relatively large.
We document that our results hold after accounting for differences in investment opportunities, business unit fixed effects, intra-division correlation, and a wide set of other controls. Moreover, we show that our sample firms is not financially constraint according to measures used in the literature and that the firm did not sell the equity stakes as no other funds were available to finance the investment of its business units. This further mitigates that the cash windfalls might be endogenous (see Hovakimian and Titman (2002).
We also show that our power variables do not seem to proxy for ability. If power captures ability we would expect that our power proxies and future business unit performance are positively linked. However, we cannot find such a relation. We also show that future capital allocations are not adjusted downwards after units have received large proceeds from the cash windfalls. This is especially not the case for more powerful Division CEOs. Overall, our evidence suggests that power does not matter in the formalized allocation process (i.e., for planned capital expenditure) but rather when it comes to the ad hoc distribution of unexpected cash windfalls for which institutionalized and structured processes are less likely to be binding.
Our results are most closely related to the following papers. Rajan, Servaes and Zingales (2000) predict that whether or not a division receives or makes transfers in a conglomerate depends not so much on its own opportunities but rather on its size-weighted opportunities and to what extent they are dispersed across divisions in a firm. By assuming that dispersion is the result of power by division managers, they link the use of power inside the firm to inefficient allocations. Based on US segment data, Rajan, Servaes and Zingales (2000) find evidence that is consistent with this story. Gaspar and Massa (2007) analyze the role of bargaining power (proxied by personal connections between divisional managers and the CEO) on the allocation of resources within large corporate organizations. Using also segment level data, they find that the segments run by better connected managers receive more money. McNeil and Smythe (2009) merge Execucomp data with segment data and find that division managers’ lobbying power positively affects capital allocations. They measure power by looking at tenure, time-in-position, board membership, and top executive status. The advantage of the studies by Rajan, Servaes and Zingales (2000), Gaspar and Massa (2007) and McNeil and Smythe (2009) is that they are able to analyze a large cross section of firms. However, this comes at the cost of having not very detailed data on capital allocations, especially not planned data and data on the business unit level, and on the power structures inside firms (see Schoar (2002) or Maksimovic and Philips (2006)). Cremers, Huang and Sautner (2008) have detailed capital allocation data from a banking group and a measure of power (disproportionate voting rights inside the group). They document that power can have a bright side by overcoming asymmetric information problems within firms leading to more efficient capital allocations.
Beyond documenting the effects of power, we exploit our planning data to mitigate problems of measurement error in proxies for expected investment profitability (such as Tobin’s Q, see, e.g., Erickson and Whited (2000) and Whited (2001)). Apart from relying on measures of imputed Tobin’s Q, we are able to use the planned investment profitability measures which are actually employed by the firm. These variables are Planned Sales Growth, Planned Return on Assets (Planned EBIT/Total Assets), and Planned Economic Value Added (EVA), and the corresponding values are available from the time when the firm’s ex ante plans were made. Our present study is thus also related to a recent paper by Cummins, Hassett and Oliner (2006). They address the problem of measurement error in Tobin’s Q by using firm-specific earnings forecasts from securities analysts to construct a measure of investment opportunities which does not rely on the stock market. Analysts’ forecasts are used to capture the expected future returns on which the firm’s investment decisions are based. Cummins, Hassett and Oliner (2006) find that investment responds significantly to their measure of expected investment profitability while cash flow seems to be insensitive. Thus, the approach taken by Cummins, Hassett and Oliner (2006) and our study can be regarded as complementary methods which both provide ways to mitigate problems related to measurement error in Tobin’s Q.
The rest of this paper is organized as follows. In Section 2, we describe models that study the effect of bargaining power on the allocation of capital. Section 3 describes the sample firm and presents the data set that is used in our study. Moreover, we deal with the question whether our sample firm is representative for other large manufacturing conglomerates. Section 4 documents the capital budgeting process in our firm and describes our power proxies. While Section 5 presents results on whether managerial power affects the (ex ante) planned capital allocations, Section 6 shows results on the effect of power for the distribution of cash windfalls. Section 7 discusses alternative explanations, and the last section of the paper summarizes our results and concludes.
