A q Theory of Internal Capital Markets

We propose a tractable model of dynamic investment, spinoffs, financing, and risk management for a multi-division firm facing costly external finance. Our main results are: (1) within-firm resource allocation is based not only on the divisions’ productivity—as in “winner picking” models—but also their risk; (2) firms may voluntarily spin off productive divisions to increase liquidity; (3) diversification can reduce firm value in low-liquidity states; (4) corporate socialism makes liquidity less valuable; (5) division investment is determined by the ratio between marginal q and marginal value of cash. We further generalize our model to account for capital redeployability, M&As, and managerial entrenchment.