Internal Capital Allocation, Voluntary Disclosure, and Investment Efficiency

I develop an analytical model to examine the effect of disclosure on organizational structure. In this model, an owner with two investment projects decides whether to organize them as a single multidivisional firm or two stand-alone firms whose manager(s) may issue a truthful but costly disclosure of each project’s profitability to raise capital. In a multidivisional firm, capital is initially provided by investors and subsequently allocated across the two projects by the manager. The analysis shows that a multidivisional structure allows for efficient internal capital allocation while avoiding disclosure costs, whereas a stand-alone structure prevents inefficient cross-subsidization. Specifically, a multidivisional structure is optimal when disclosure costs are high relative to project payoffs. These results help explain empirical evidence that multidivisional firms tend to trade at a discount. This paper was accepted by Ranjani Ananthakrishnan, accounting.