Ch. 8: Conglomerate Firms and Internal Capital Markets 451
is usually proxied by the firm’s average Tobin’sq.^25 For conglomerate segments we
cannot observe the segment’s averageqdirectly, but must use a proxy. The usual proxies
in the diversification literature are based on the average or median Tobin’sqs of single-
segment firms operating in segmentj’s industry.
When equation(4)is run via OLS, the coefficientβis higher in single-segment
firms than in conglomerates, suggesting that conglomerates’ segments are insuffi-
ciently responsive to differences in investment opportunities. This implies that con-
glomerates overinvest when opportunities are low and underinvest when they are better
(Scharfstein, 1998).
A second set of tests recognizes that in an imperfect financial market the firm’s in-
vestment expenditures may depend on its cash flow as well as on its marginal Tobin’sq.
For a conglomerate, a segment’s investment may depend both on its own cash flows and
on the cash flows of the whole firm. Thus, we can augment the investment equation by
putting in the cash flows of the segment and that of the whole firm in the investment
equation,
ij=zjγ+qjβ+δCFj+φCF−j+ζj, (5)where CFjis the cash flow of segmentjand CF−jis the cash flow of entire conglom-
erate less segmentj.
Shin and Stulz (1998)argue that if the internal capital market is working efficiently
investment will not depend on a segment’s cash flow but on that of the firm as a whole
andφδ.
It is reasonable to suppose that in an efficient internal capital market the level of
investment in one segment will be affected by the level of investment opportunities in
other segments. Thus, as further test of the efficiency of the internal capital market equa-
tion(5)can be augmented by estimates of Tobin’sqfor the firm’s other segments−j.
Using COMPUSTATShin and Stulz (1998)examine the workings of internal capital
markets of about 14,000 conglomerates for the period 1980 to 1992, paying careful at-
tention to data issues (see the Appendix to their paper). They find that (a) the investment
of a conglomerate segment depends more on its own cash flows than on the cash flows
of the firm’s other segments (δexceedsφ); (b) in highly diversified firms, a segment’s
cash flow is less sensitive to its cash flow than in comparable single-segment firms,
(c) a segment’s investment increases with itsqbut is not related to the other segments’
qs, and (d) the segments with the highestqs have the same cash flow sensitivityδas
other segments.
In sum,Shin and Stulz (1998)find that the internal capital market does not equalize
the effect of cash shortfalls across segments. At the same time, a segment’s investment is
affected by the cash flows of the other segments, notwithstanding differences in Tobin’s
qacross segments. They conclude that conglomerates internal capital markets do not
meet their standard of efficiency.
(^25) SeeHayashi (1982)andAbel and Eberly (1994)for the conditions under which the marginal Tobin’sqis
well proxied by the average Tobin’sq.