Capital and Labor Reallocation within Firms

• Author: XAVIER GIROUD,HOLGER M. MUELLER
• Published date: 01 August 2015
• DOI: http://doi.org/10.1111/jofi.12254
• Date: 01 August 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 4 •AUGUST 2015

Capital and Labor Reallocation within Firms

XAVIER GIROUD and HOLGER M. MUELLER∗

ABSTRACT

We document how a positive shock to investment opportunities at one plant (“treated

plant”) spills over to other plants within the same firm, but only if the firm is fi-

nancially constrained. To provide the treated plant with resources, the firm’s head-

quarters withdraws capital and labor from other plants, especially plants that are

relatively less productive, not part of the firm’s core industries, and located far away

from headquarters. As a result of the resource reallocation, aggregate firm-wide pro-

ductivity increases. We do not find evidence of capital or labor spillovers among plants

of financially unconstrained firms.

The “efficient internal capital markets hypothesis” postulates that corporate

headquarters, by virtue of its control rights, can create value by actively re-

allocating scarce resources across projects (see, for example, Alchian (1969),

Williamson (1975), Stein (1997)). By contrast, an external lender, such as

a bank, does not possess the authority to reallocate scarce resources across

borrowers.

This fundamental idea—that headquarters can create value by actively re-

allocating scarce resources—is testable. Stein (1997, p. 112) formulates the

efficient internal capital markets hypothesis as follows:

Thus, for example, if a company owns two unrelated divisions A and B,

and the appeal of investing in B suddenly increases, the argument would

∗Giroud is with the MIT Sloan School of Management and NBER; Mueller is with the NYU

Stern School of Business, NBER, CEPR, and ECGI. We thank Michael Roberts (the Editor), two

anonymous referees, our discussants Owen Lamont (NBER) and Hyunseob Kim (UNC Junior

Faculty Roundtable), and seminar participants at the NBER Corporate Finance Summer Insti-

tute, Micro@Sloan Conference, UNC Junior Faculty Roundtable, University of Chicago (Booth),

Massachusetts Institute of Technology (Sloan), New York University (Stern), Harvard Business

School, London Business School, London School of Economics, Duke University (Fuqua), Cornell

University (Johnson), Washington University in St. Louis (Olin), University of Maryland (Smith),

University of British Columbia (Sauder), Dartmouth College (Tuck), University of Utah (Eccles),

Arizona State University (Carey), Georgia Institute of Technology(Scheller), INSEAD, HEC Paris,

Stockholm School of Economics, City University (Cass), University of Florida (Warrington), Uni-

versity of Western Ontario (Ivey), Bentley University, WU Vienna, and Humboldt University for

helpful comments. The research in this paper was conducted while the authors were Special Sworn

Status researchers of the U.S. Census Bureau at the New York and Boston Census Research Data

Centers. Any opinions and conclusions expressed herein are those of the authors and do not nec-

essarily represent the views of the U.S. Census Bureau. All results have been reviewed to ensure

that no confidential information is disclosed.

DOI: 10.1111/jofi.12254

1767

1768 The Journal of Finance R

seem to imply that investment in A would decline—even if it is positive

NPV at the margin—as corporate headquarters channels relatively more

of its scarce resources toward B.1

Little is known about whether this hypothesis holds in the data. The pa-

per that perhaps comes closest to testing this hypothesis is Shin and Stulz

(1998). Using Compustat segment data, the authors regress investment by a

segment on the industry Qs of the firm’s other segments. They overwhelmingly

reject the view that the industry Qs of the other segments affect the segment’s

investment, concluding that “unless one believes that firms face no costs of

external finance, this evidence suggests that the internal capital market does

not allocate resources efficiently” (Shin and Stulz (1998, p. 544)).

This paper takes a fresh look at the efficient internal capital markets hy-

pothesis. Using plant-level data from the U.S. Census Bureau, we consider a

natural experiment that is close in spirit to the thought experiment outlined

in Stein’s quote. To obtain exogenous variation in the “sudden increase in the

appeal of investing in a plant,” we use the introduction of new airline routes

that reduce the travel time between headquarters and plants. Giroud (2013)

uses this source of variation to study whether proximity to headquarters af-

fects plant-level investment. The idea is that a reduction in travel time makes

it easier for headquarters to monitor a plant, give advice, share knowledge,

etc., raising the plant’s marginal productivity and thus making investment in

the (treated) plant more appealing.2,3Consistent with this idea, Giroud finds

that a reduction in travel time leads to an increase in plant-level productivity

and investment.

In this paper, we use the “sudden increase in the appeal of investing in a

plant” as our starting point and ask whether it leads to a reallocation of re-

sources within the firm. Theory predicts that headquarters should withdraw

resources from existing plants only if the firm is financially constrained. Ac-

cordingly, we separately examine financially constrained and unconstrained

firms. We also examine whether, to provide the treated plant with resources,

headquarters selectively “taxes” some plants more than others. We finally

1Similarly, Shin and Stulz (1998, p. 543) define an internal capital market as efficient if “its

allocation of funds to a segment falls when other segments have better investment opportunities.”

2The main reason for using travel time instead of geographical proximity is that plant location

is endogenous. By contrast, holding plant location fixed, variation in travel time is plausibly

exogenous with respect to plant-level outcomes. A second reason is that travel time constitutes a

more direct proxy for the ease of monitoring. For example, a plant may be located far away from

headquarters, yet monitoring may be easy because there exists a short direct flight. Conversely, a

plant may be located in the same state as headquarters, yet monitoring may be costly because it

involves a long trip by car.

3Anecdotal evidence that proximity facilitates monitoring abound. For example, Ray Kroc,

founder of McDonald’s, writes in his autobiography that “One thing I liked about that house was

that it was perched on a hill looking down on a McDonald’s store on the main thoroughfare. I could

pick up a pair of binoculars and watch business in that store from my living room window.It drove

the manager crazy when I told him about it. But he sure had one hell of a hard-working crew”

(Kroc (1992, p. 141)).

Capital and Labor Reallocation within Firms 1769

examine whether the reallocation is beneficial for the firm as a whole, as argued

by the efficient internal capital markets hypothesis.

The main identification challenge comes from local shocks at the plant level.

For instance, suppose a plant is located in a region that experiences an economic

boom. As a result, headquarters may find it more attractive to invest in the

plant. By the same token, airlines may find it more attractive to introduce new

routes to the plant’s location. Thus, local shocks may be driving both plant-

level investment and the introduction of new airline routes. Fortunately, we

can control for such local shocks by including a full set of location-year fixed

effects. The fixed effects are identified because not all local plants have their

headquarters in the same region.

Controlling for local shocks also matters with regard to the firm’s other

(that is, nontreated) plants. In particular, it implies that a decline in resources

at these plants is not simply due to an adverse local shock that might have

affected the plants anyway, that is, if they had been stand-alone entities. Thus,

controlling for local shocks allows us to address a key premise of the theory of

the firm, namely, that combining different projects under one roof creates an

interdependence among projects.

Our plant-level results support the hypothesis that headquarters reallocates

scarce resources across plants. For financially constrained firms, we find that

investment and employment both increase at the treated plant, while they both

decline at other plants within the same firm. Indeed, the increase at the treated

plant is of similar magnitude as the decline at the other plants: investment

(employment) at the treated plant increases by $186,000 (five employees), while

it declines by $179,000 (six employees) at all other plants combined. In contrast,

we find no evidence of investment or employment spillovers among plants of

financially unconstrained firms.

If headquarters actively reallocates scarce resources across plants, then the

increase in investment and employment at the treated plant and the decline

at the other plants should occur around the same time. We find that this is

indeed the case: the increase at the treated plant and the decline at the other

plants both begin about one year after the treatment. Moreover, we find no

pre-existing differential trends, strengthening a key identifying assumption

underlying our analysis.

While the firm’s other plants experience a decline in resources, the average

spillover effect is relatively weak. There are several reasons for this. First, the

amount of resources needed to “feed” the treated plant—and thus the amount

that must be taken away from the other plants—is relatively modest. Second,

this amount is divided among many other plants, implying that the average

amount that is taken away from any individual plant is small. Indeed, when we

focus on firms that have relatively few other plants, the spillover effect becomes

much stronger. Third, the average spillover effect is likely to be noisy. Presum-

ably, headquarters does not “tax” all of the firm’s other plants equally: while

some plants may experience a large drop in resources, others may experience

none. To examine this hypothesis, we look at various plant characteristics. We

find that headquarters is more likely to take resources away from plants that