1998) are among the first to study internal capital market in the context of capital allocation among divisions. In their model, a firm’s headquarters has control over budget allocation, but divisional managers have better information about profitability and investment opportunities of their own divisions. In addition to information asymmetry, there are conflicts of interest between firm’s headquarters and divisions because their interests are not perfectly aligned. As a result, the headquarters may make suboptimal capital allocation decisions: some divisions with good projects may not receive the budget they deserve while those without good projects may end up with more than what they need to implement their positive NPV projects. One particular manifestation of capital allocation inefficiency is documented in the finance and accounting literature. Shin and Kim (2002), Callen, Livnat, and Ryan (1996), and Kinney and Trezevant (1993) show that firms in the U.S. market tend to make fixed investments more aggressively in the fourth fiscal quarter than in the other three. In particular, Shin and Kim (2002) find that this fourth fiscal quarter over-investment (hereafter quarter effect”) is due to the it or lose it” budget rule, combined “fourth “use with conflicts of interest and information asymmetry between headquarters and divisions. They argue that divisional managers have incentives to increase, or at least maintain current budget allocations for the following fiscal year, and therefore tend to use up their remaining budget by the fiscal year-end even if they do not have good investment opportunities. We investigate this quarter effect” in corporate investment, and attempt to address two “fourth questions. we examine whether the quarter effect” is present in other countries. A positive “fourth answer to this question would alleviate the concern that this effect documented in the U.S. is just a coincidence. Second, and more importantly, unlike earlier papers that concentrate only on the conflicts of interest between the headquarters and divisional managers, we examine the external agency conflicts and characteristics of business environments. Our study is motivated by the two-tiered agency model on internal capital market by Scharfstein and Stein (2000). In their internal capital allocation model, the firm has the headquarters, a high-productivity division, and a low-productivity division. There are two layers of agency conflicts: the inner-layer between headquarters and divisional managers, and the outer-layer
1998) are among the first to study internal capital market in the context of capital allocation among divisions. In their model, a firm’s headquarters has control over budget allocation, but divisional managers have better information about profitability and investment opportunities of their own divisions. In addition to information asymmetry, there are conflicts of interest between firm’s headquarters and divisions because their interests are not perfectly aligned. As a result, the headquarters may make suboptimal capital allocation decisions: some divisions with good projects may not receive the budget they deserve while those without good projects may end up with more than what they need to implement their positive NPV projects. One particular manifestation of capital allocation inefficiency is documented in the finance and accounting literature. Shin and Kim (2002), Callen, Livnat, and Ryan (1996), and Kinney and Trezevant (1993) show that firms in the U.S. market tend to make fixed investments more aggressively in the fourth fiscal quarter than in the other three. In particular, Shin and Kim (2002) find that this fourth fiscal quarter over-investment (hereafter “fourth quarter effect”) is due to the “use it or lose it” budget rule, combined with conflicts of interest and information asymmetry between headquarters and divisions. They argue that divisional managers have incentives to increase, or at least maintain current budget allocations for the following fiscal year, and therefore tend to use up their remaining budget by the fiscal year-end even if they do not have good investment opportunities. We investigate this “fourth quarter effect” in corporate investment, and attempt to address two questions. we examine whether the “fourth quarter effect” is present in other countries. A positive answer to this question would alleviate the concern that this effect documented in the U.S. is just a coincidence. Second, and more importantly, unlike earlier papers that concentrate only on the conflicts of interest between the headquarters and divisional managers, we examine the external agency conflicts and characteristics of business environments. Our study is motivated by the two-tiered agency model on internal capital market by Scharfstein and Stein (2000). In their internal capital allocation model, the firm has the headquarters, a high-productivity division, and a low-productivity division. There are two layers of agency conflicts: the inner-layer between headquarters and divisional managers, and the outer-layer