Internal versus External Financing: An Optimal Contracting Approach

We study optimal financial contracting for centralized and decentralized firms. Under centralized contracting, headquarters raises funds on behalf of multiple projects. Under decentralized contracting, each project raises funds separately on the external capital market. The benefit of centralization is that headquarters can use excess liquidity from high cash-flow projects to buy continuation rights for low cash-flow projects. The cost is that headquarters may pool cash flows from several projects and self-finance follow-up investments without having to return to the capital market. Absent any capital market discipline, it is more difficult to force headquarters to make repayments, which tightens financing constraints ex ante. Cross-sectionally, our model implies that conglomerates should have a lower average productivity than stand-alone firms. Copyright 2003 by the American Finance Association.