Internal Capital Markets and Firm-Level Compensation Incentives for Division Managers

Do multi-divisional firms structure compensation contracts for division managers to mitigate information and incentive problems in their internal capital markets? Using Compustat Segment financial data and compensation data from a proprietary survey, I find evidence that compensation and investment incentives are substitutes: firms providing a stronger link to firm performance in incentive compensation for division managers also provide weaker investment incentives through the capital budgeting process. Specifically, as the proportion of incentive pay for division managers that is based on firm performance increases, division investment is less responsive to division profitability. While these findings may be consistent with other explanations, they are generally consistent with a model of influence activities by division managers and the implied relative weights placed on imperfect, objective signals (i.e. accounting measures) versus distortable, subjective signals (i.e. manager recommendations) in inter-divisional capital allocation decisions. *I wish to thank Stan Baiman, Severin Borenstein, Brian Hall, Charlie Himmelberg, Bob Holthausen, Dan Levinthal, Maggie McMillan, Ron Miller, Andy Newman, Felix Oberholzer-Gee, Scott Stern, Louis Thomas and Joel Waldfogel for their comments and suggestions and Raffi Indjejikian, Dave Larcker and Abbie Smith for access to the compensation data. I would also like to thank participants at the Wharton Applied Economics Workshop and Finance Department Lunch, the American Compensation Association’s Academic Research Conference, Berkeley’s Institutional Analysis Workshop and Washington University’s Strategy Seminar. 2000 Steinberg-Dietrich Hall, Rm 2031, University of Pennsylvania, Philadelphia, PA 19104 Email: [email protected]