Internal vs. 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 and subsequently allocates the funds on the firm's internal capital market. 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. This allows headquarters to make greater repayments to investors, which eases financing constraints ex ante. 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 for investors to force headquarters to make repayments, which tightens financing constraints. Trading off these costs and benefits we finally derive the boundaries of the firm