Ch. 8: Conglomerate Firms and Internal Capital Markets 441
manager’s utility function because it affects the value of his proprietary benefits. Given
the assumed relation between diversification and value, and the assumed compensation
contract, the firm’s directors can affect the manager’s actions by tying his rewards to
performance.
The board of directors offer the CEO a linear contract based onπandn. The CEO
chooses the level of diversificationnand effortx.Theπis realized and the CEO is
compensated onπandn.
This framework leads to some interesting predictions, which differ from those that
would be derived by intuition alone. For example, suppose that there is an exogenous
increase in the amount of private benefits that the manager can gain from diversifica-
tion that is value destroying for the firm. In equilibrium it would be optimal to increase
his performance pay in order to reduce his incentive to diversify. However, in an in-
terior equilibrium this increase will not be enough to totally negate the effect of the
exogenous increase in private benefits from diversification. As a result, empirically we
would observe contemporaneous increases in incentive based pay and in diversification.
However, the positive correlation would not be an indication of a causal relation. More
generally, the empirical relation between incentives and diversification shows that the
interpretation of simple correlations between incentive based compensation and diver-
sification is not straightforward.
Aggarwal and Samwick (2003)derive testable relations regarding changes in firm
value, incentive compensation and level of diversification in response to changes in
exogenous parameters, such as managerial risk aversion or the ability to gain pri-
vate benefits from diversification. They estimate this relation on about 1600 firms in
the 1990s using COMPUSTAT, CRSP and ExecuComp data. The pattern of relations
they find is consistent with their model’s predictions for the case in which diversi-
fication decisions are driven by increases in managers’ private benefits from diversi-
fying.The advantage of an explicit modeling approach as inAggarwal and Samwick
(2003)is that it yields a set of transparent predictions that can be taken to data and
checked for consistency. For this clarity to be attained the researcher has to take a
point of view about the underlying relation. Other initial structures, in which, for
example, the board can monitor and approve diversification or where not all diver-
sification reduces value—may yield different predictions on the value of diversifica-
tion.
3.4. Diversification and the power within the firm
Another strand in the literature argues that investment decisions within diversified firms
are driven by the need to moderate conflicts of interests between different divisions
and different levels of the hierarchy within the firm. The starting point for this research
are the observations byLamont (1997)andShin and Stulz (1998)that diversified firms
capital expenditures are not as sensitive to proxies of industry opportunities as focused
firms. Such distortions would be unlikely to occur in the standard agency framework
where the CEO has an incentive to maximize firm value so as to maximize his ability