Internal capital markets, empire building, and capital structure

Internal funds generated by assets in place are available to finance the bulk of new investment by nonfinancial firms. Self-interested management has incentives to misallocate these funds in order to increase their control rents. There are two ways to impact future discretionary investment. First, using debt diverts funds to creditors and away from management. Second, having in place more assets that do not provide internal financing reduces the funds subject to managerial discretion. Investment in such assets and debt financing are inversely related in controlling self-interested management. As a result, firms borrow more and own proportionally more assets that provide internal funds as the average profitability of these assets, or that of future investment, increases. Firms may borrow less while increasing investment in the less valuable assets that do not supply internal financing as the expected profitability of these assets increases. (C) 2008 Elsevier Inc. All rights reserved.