INTERNAL VERSUS EXTERNAL CAPITAL-MARKETS

This paper presents a framework for analyzing the costs and benefits o f internal versus external capital allocation. We focus primarily on c omparing an internal capital market with bank lending. While both repr esent centralized forms of financing, in the former case the financing is owner-provided, while in the latter case it is not. We argue that the ownership aspect of internal capital allocation has three importan t consequences: (1) it leads to more monitoring than bank lending; (2) it reduces managers' entrepreneurial incentives; and (3) it makes it easier to efficiently redeploy the assets of projects that are perform ing poorly under existing management.