Internal vs. External Financing: An Optimal Contracting Approach

Abstract

This paper compares optimal financial contracts with centralized and decentralized firms. Under centralized contracting headquarters raises funds on behalf of multiple projects and then allocates the funds on the firm’s internal capital market. Under decentralized contracting each project raises funds separately on the external capital market. The benefit of centralization is that headquarters can use excess liquidity from high-cash flow projects to buy continuation rights for low cash-flow projects. This allows headquarters to make greater repayments to investors, which eases financing constraints ex ante. The cost is that headquarters may pool cash flows from several projects, thereby accumulate internal funds, and make follow-up investments without having to return to the capital market. Absent any capital market discipline, however, it is more difficult for investors to force headquarters to pay out funds, which tightens ex-ante financing constraints.