Question

It is sometimes suggested that since retained earnings provide the bulk of industry’s capital needs, the securities markets are largely redundant. This is even more so for diversified firms with internal capital markets. With reference to the literaturediscuss the benefits of internal capital markets versus external capital markets

Answer 1

There are several benefits of internal capital markets over external capital markets. Firstly internal capital market provides a company with increased monitoring incentives. This is because internal sources and providers of capital will choose to monitor more intensely as residual control over the assets is present. Secondly use of internal capital market leads to better asset redeployability. This is because in the situation in which one division is performing poorly then its assets can be redeployed in an efficient manner in other divisions or units.

External capital markets score over the internal capital market as the internal capital market leads to decreased entrepreneurial incentives in most cases while this does not happen with external capital markets. When control rights are given to capital providers using the internal capital allocation process then it will lead to reduction of managerial incentives as the manager’s control will be diluted and the manager will become more susceptible to the opportunistic behavior of the senior management.