Efficiency of the internal capital markets and corporate spinoff decision

I provide evidence on the inefficient internal capital market hypothesis by examining the separation of a conglomerate through a spinoff. I document that (i) pre-spinoff firms are valued less than a portfolio of the industry matched single segment firms be cause headquarters allocates funds inefficiently, and (ii) a spinoff removes the diversification discount through elimination of the inefficiency in internal capital market. There is little evidence, however, that low q segments are overinvesting or supported by funds generated from other segments. The inefficiency of investment before a spinoff is mostly due to underinvestment in high q segments, and the improvement in the efficiency of investment after the spinoff is mostly due to the increase of investment in high q segments. These findings suggest that pre-spinoff firms allocate funds inefficiently in the sense that headquarters does not give priority to high q segments in its capital allocation decision making.; Further tests show that firm-level financial policy may drive underinvestment in high q segments in the pre-spinoff period. Because the financial policy in the pre-spinoff period is more suitable for a core segment, the change in financial policy after the spinoff is more evident in the separating entity than in the remaining entity. High q firms significantly increase discretionary cash flow by reducing interest payments and dividend payments after the spinoff. The increase of discretionary cash flow in high q firms is not simply the result of the improvement in operating performance. Although low q firms also change their financial policies after the spinoff, the discretionary cash flow does not change. The increase in discretionary cash flow in high q firms and the insignificant change in discretionary cash flow in low q firms are consistent with the increase in investment in high q segments and the insignificant change in investment in low q segments after the spinoff.