Internal Capital Markets and Investment Policy : Evidence from Corporate Spinoffs

We analyze changes in investment policy following 106 spinoffs completed by diversified firms between 1981 and 1996. Prior to the spinoff, the sample firms are valued at a discount relative to a portfolio of comparable single-segment firms, and allocate funds inefficiently, investing too little in high-q segments. Following the spinoff, there is a significant improvement in investment efficiency and the diversification discount is eliminated. Furthermore, changes in excess value around the spinoff are positively related to changes in measures of investment efficiency. These findings support the view that (i) diversified firms allocate investment funds inefficiently, and (ii) by breaking up the conglomerate, spinoffs create value by improving investment efficiency