Rethinking Internalization Theory due to Coase’s “Hidden in Plain Sight” Assumption

Coase assumed that firms only use balance-sheet financing for their capital investments. Other forms of financing exist, and as shown, the process by which economic utility theory gets applied to Internalization Theory is found to be contingent on the method of financing. Coase’s underlying financing assumption causes the long-standing Investment Opportunity Schedule (IOS) to yield erroneous results when applied to project-financed investments. This is significant because project financing is now a $200+ billion annual global market and widely used to finance electric power projects and numerous other capital-intensive investments. A new investment ranking mechanism (the MIOS) is proposed and shown to be the proper ranking mechanism for project-financed investment opportunities. Support is found for the new investment ranking mechanism using a paired comparison methodology which yields the ranking of the potential investments to be internalized as well as the placement of the equilibrium point. As shown, the Coasian IOS is not universal, but rather, is contingent on the method of financing. Thus, the answers to Coase’s two seminal questions which form the basis for Internalization Theory (Which business opportunities should be internalized by a firm?, and What should be the extent or boundary of a firm?) are also shown to be contingent on the method of financing. The IOS and the MIOS, working in tandem, provide a better foundation for Internalization Theory. JEL Codes : D21, D23, G31.